10-Q 1 w71392e10vq.htm 10-Q 10-Q
Table of Contents

 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
Form 10-Q
 
     
     
þ
  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
     
    For the quarterly period ended September 30, 2008
OR
     
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
     
    For the transition period from          to          
 
Commission File No.: 0-50231
 
Federal National Mortgage Association
(Exact name of registrant as specified in its charter)
 
Fannie Mae
 
     
Federally chartered corporation
(State or other jurisdiction of
incorporation or organization)
  52-0883107
(I.R.S. Employer
Identification No.)
     
3900 Wisconsin Avenue, NW
Washington, DC
(Address of principal executive offices)
  20016
(Zip Code)
 
Registrant’s telephone number, including area code:
(202) 752-7000
 
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
             
Large accelerated filer þ
  Accelerated filer o   Non-accelerated filer o
(Do not check if a smaller reporting company)
  Smaller reporting company o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ
 
As of September 30, 2008, there were 1,076,207,174 shares of common stock outstanding.
 


Table of Contents

 
TABLE OF CONTENTS
 
                 
    1  
      Financial Statements     142  
        Condensed Consolidated Balance Sheets     142  
        Condensed Consolidated Statements of Operations     143  
        Condensed Consolidated Statements of Cash Flows     144  
        Condensed Consolidated Statements of Changes in Stockholders’ Equity     145  
          Note 1— Organization and Conservatorship     146  
          Note 2— Summary of Significant Accounting Policies     148  
          Note 3— Consolidations     154  
          Note 4— Mortgage Loans     155  
          Note 5— Allowance for Loan Losses and Reserve for Guaranty Losses     157  
          Note 6— Investments in Securities     159  
          Note 7— Financial Guarantees     162  
          Note 8— Acquired Property, Net     164  
          Note 9— Short-Term Borrowings and Long-Term Debt     165  
          Note 10— Derivative Instruments and Hedging Activities     167  
          Note 11— Income Taxes     169  
          Note 12— Earnings (Loss) Per Share     171  
          Note 13— Employee Retirement Benefits     172  
          Note 14— Segment Reporting     173  
          Note 15— Stockholders’ Equity     176  
          Note 16— Regulatory Capital Requirements     181  
          Note 17— Concentrations of Credit Risk     182  
          Note 18— Fair Value of Financial Instruments     185  
          Note 19— Commitments and Contingencies     198  
      Management’s Discussion and Analysis of Financial Condition and Results of Operations     1  
      Introduction     1  
      Executive Summary     2  
      Selected Financial Data     16  
      Description of Our Business     20  
      Conservatorship and Treasury Agreements     26  
      Critical Accounting Policies and Estimates     36  
      Consolidated Results of Operations     43  
      Business Segment Results     67  
      Consolidated Balance Sheet Analysis     72  
      Supplemental Non-GAAP Information — Fair Value Balance Sheets     88  
      Liquidity and Capital Management     93  
      Off-Balance Sheet Arrangements and Variable Interest Entities     109  
      Risk Management     110  
      Impact of Future Adoption of Accounting Pronouncements     139  
      Forward-Looking Statements     139  
      Quantitative and Qualitative Disclosures About Market Risk     208  
      Controls and Procedures     208  


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    210  
      Legal Proceedings     210  
      Risk Factors     215  
      Unregistered Sales of Equity Securities and Use of Proceeds     235  
      Defaults Upon Senior Securities     238  
      Submission of Matters to a Vote of Security Holders     238  
      Other Information     238  
      Exhibits     238  


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MD&A TABLE REFERENCE
 
             
Table
 
Description
  Page
 
  Selected Financial Data     16  
1
  Level 3 Recurring Financial Assets at Fair Value     38  
2
  Summary of Condensed Consolidated Results of Operations     43  
3
  Analysis of Net Interest Income and Yield     44  
4
  Rate/Volume Analysis of Net Interest Income     46  
5
  Guaranty Fee Income and Average Effective Guaranty Fee Rate     48  
6
  Investment Gains (Losses), Net     50  
7
  Fair Value Gains (Losses), Net     52  
8
  Derivatives Fair Value Gains (Losses), Net     53  
9
  Credit-Related Expenses     56  
10
  Allowance for Loan Losses and Reserve for Guaranty Losses (Combined Loss Reserves)     57  
11
  Statistics on Delinquent Loans Purchased from MBS Trusts Subject to SOP 03-3     60  
12
  Activity of Delinquent Loans Purchased from MBS Trusts Subject to SOP 03-3     60  
13
  Re-performance Rates of Seriously Delinquent Single-Family Loans Purchased from MBS Trusts     61  
14
  Re-performance Rates of Seriously Delinquent Single-Family Loans Purchased from MBS Trusts and Modified     62  
15
  Required and Optional Purchases of Single-Family Loans from MBS Trusts     63  
16
  Credit Loss Performance Metrics     64  
17
  Single-Family Credit Loss Sensitivity     66  
18
  Single-Family Business Results     68  
19
  HCD Business Results     70  
20
  Capital Markets Group Results     71  
21
  Mortgage Portfolio Activity     72  
22
  Mortgage Portfolio Composition     74  
23
  Trading and Available-for-Sale Investment Securities     76  
24
  Investments in Private-Label Mortgage-Related Securities and Mortgage Revenue Bonds     77  
25
  Delinquency Status of Loans Underlying Alt-A and Subprime Private-Label Securities     79  
26
  Investments in Alt-A Private-Label Mortgage-Related Securities, Excluding Wraps     81  
27
  Investments in Subprime Private-Label Mortgage-Related Securities, Excluding Wraps     83  
28
  Alt-A and Subprime Private-Label Wraps     85  
29
  Changes in Risk Management Derivative Assets (Liabilities) at Fair Value, Net     87  
30
  Supplemental Non-GAAP Consolidated Fair Value Balance Sheets     89  
31
  Non-GAAP Estimated Fair Value of Net Assets (Net of Tax Effect)     91  
32
  Selected Market Information     93  
33
  Outstanding Short-Term Borrowings and Long-Term Debt     96  
34
  Maturity Profile of Outstanding Short-Term Debt     97  
35
  Maturity Profile of Outstanding Long-Term Debt     97  
36
  Debt Activity     98  
37
  Fannie Mae Credit Ratings     101  


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Table
 
Description
  Page
 
38
  Cash and Other Investments Portfolio     103  
39
  Regulatory Capital Measures     106  
40
  On- and Off-Balance Sheet MBS and Other Guaranty Arrangements     109  
41
  Composition of Mortgage Credit Book of Business     111  
42
  Risk Characteristics of Conventional Single-Family Business Volume and Mortgage Credit Book of Business     113  
43
  Serious Delinquency Rates     117  
44
  Nonperforming Single-Family and Multifamily Loans     118  
45
  Single-Family and Multifamily Foreclosed Properties     119  
46
  Mortgage Insurance Coverage     124  
47
  Credit Loss Exposure of Risk Management Derivative Instruments     128  
48
  Activity and Maturity Data for Risk Management Derivatives     134  
49
  Fair Value Sensitivity of Net Portfolio to Changes in Level and Slope of Yield Curve     136  
50
  Duration Gap     137  
51
  Interest Rate Sensitivity of Financial Instruments     138  


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PART I—FINANCIAL INFORMATION
 
Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
You should read this Management’s Discussion and Analysis of Financial Condition and Results of Operations, or MD&A, in conjunction with our unaudited condensed consolidated financial statements and related notes, and the more detailed information contained in our Annual Report on Form 10-K for the year ended December 31, 2007 (“2007 Form 10-K”). The results of operations presented in our unaudited condensed consolidated financial statements and discussed in MD&A do not necessarily indicate the results that may be expected for the full year.
 
The Director of the Federal Housing Finance Agency, or FHFA, our safety, soundness and mission regulator, appointed FHFA as conservator of Fannie Mae on September 6, 2008. As conservator, FHFA succeeded to all rights, titles, powers and privileges of the company, and of any stockholder, officer or director of the company with respect to the company and our assets. Following the conservator’s taking control of the company, a variety of factors that affect our business, results of operations, financial condition, liquidity position, net worth, corporate structure, management, business strategies and objectives, and controls and procedures changed materially prior to the end of the third quarter of 2008.
 
Please refer to “Description of our Business” below for a description of our business and to “Executive Summary” and “Conservatorship and Treasury Agreements” below for more information on the conservatorship and its impact on our business. Refer to “Glossary of Terms Used in this Report” in our 2007 10-K for an explanation of key terms used throughout this discussion.
 
INTRODUCTION
 
Fannie Mae is a government-sponsored enterprise, or GSE, that was chartered by Congress to support liquidity and stability in the secondary mortgage market, where existing mortgage loans are purchased and sold. We do not make mortgage loans to borrowers or conduct any other operations in the primary mortgage market, which is where mortgage loans are originated.
 
We securitize mortgage loans originated by lenders in the primary mortgage market into mortgage-backed securities that we refer to as Fannie Mae MBS. We describe the securitization process under “Description of Our Business.” We also participate in the secondary mortgage market by purchasing mortgage loans (often referred to as “whole loans”) and mortgage-related securities, including our own Fannie Mae MBS, for our mortgage portfolio.
 
The Federal Housing Finance Regulatory Reform Act of 2008, referred to as the Regulatory Reform Act, was signed into law by President Bush on July 30, 2008 and became effective immediately. The Regulatory Reform Act established FHFA as an independent agency with general supervisory and regulatory authority over Fannie Mae, Freddie Mac and the 12 Federal Home Loan Banks. FHFA assumed the duties of our former regulators, the Office of Federal Housing Enterprise Oversight, or OFHEO, and the Department of Housing and Urban Development, or HUD, with respect to safety, soundness and mission oversight of Fannie Mae and Freddie Mac. HUD remains our regulator with respect to fair lending matters. We reference OFHEO in this report with respect to actions taken by our safety and soundness regulator prior to the creation of FHFA on July 30, 2008.


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EXECUTIVE SUMMARY
 
Our “Executive Summary” presents a high-level overview of the most significant factors that our management has focused on in currently evaluating our business and financial position and prospects, in addition to highlighting changes in business operations and strategies, structure, and controls since we were placed into conservatorship that we believe are significant.
 
Entry Into Conservatorship and Treasury Agreements
 
On September 7, 2008, Henry M. Paulson, Jr., Secretary of the U.S. Department of the Treasury, or Treasury, and James B. Lockhart III, Director of FHFA announced several actions taken by Treasury and FHFA regarding Fannie Mae. Mr. Lockhart stated that they took these actions “to help restore confidence in Fannie Mae and Freddie Mac, enhance their capacity to fulfill their mission, and mitigate the systemic risk that has contributed directly to the instability in the current market.” These actions included the following:
 
  •  placing us in conservatorship;
 
  •  the execution of a senior preferred stock purchase agreement by our conservator, on our behalf, and Treasury, pursuant to which we issued to Treasury both senior preferred stock and a warrant to purchase common stock; and
 
  •  the agreement to establish a temporary secured lending credit facility that is available to us.
 
Entry into Conservatorship
 
On September 6, 2008, at the request of the Secretary of the Treasury, the Chairman of the Board of Governors of the Federal Reserve and the Director of FHFA, our Board of Directors adopted a resolution consenting to putting the company into conservatorship. After obtaining this consent, the Director of FHFA appointed FHFA as our conservator on September 6, 2008, in accordance with the Regulatory Reform Act and the Federal Housing Enterprises Financial Safety and Soundness Act of 1992.
 
Upon its appointment, the conservator immediately succeeded to all rights, titles, powers and privileges of Fannie Mae, and of any stockholder, officer or director of Fannie Mae with respect to Fannie Mae and its assets, and succeeded to the title to all books, records and assets of Fannie Mae held by any other legal custodian or third party. The conservator has the power to take over our assets and operate our business with all the powers of our stockholders, directors and officers, and to conduct all business of the company. The conservator announced at that time that it would eliminate the payment of dividends on common and preferred stock during the conservatorship.
 
On September 7, 2008, the Director of FHFA issued a statement that he had determined that we could not continue to operate safely and soundly and fulfill our critical public mission without significant action to address FHFA’s concerns, which were principally: safety and soundness concerns as they existed at that time, including our capitalization; market conditions; our financial performance and condition; our inability to obtain funding according to normal practices and prices; and our critical importance in supporting the U.S. residential mortgage market. We describe the terms of the conservatorship and the powers of our conservator in detail below under “Conservatorship and Treasury Agreements—Conservatorship.”
 
Overview of Treasury Agreements
 
Senior Preferred Stock Purchase Agreement
 
The conservator, acting on our behalf, entered into a senior preferred stock purchase agreement with Treasury on September 7, 2008. This agreement was amended and restated on September 26, 2008. We refer to this agreement as the “senior preferred stock purchase agreement.” Under that agreement, Treasury provided us with its commitment to provide up to $100 billion in funding under specified conditions. The agreement requires Treasury, upon the request of the conservator, to provide funds to us after any quarter in which we have a negative net worth (that is, our total liabilities exceed our total assets, as reflected on our GAAP


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balance sheet). In addition, the agreement requires Treasury, upon the request of the conservator, to provide funds to us if the conservator determines, at any time, that it will be mandated by law to appoint a receiver for us unless we receive funds from Treasury under the commitment. In exchange for Treasury’s funding commitment, we issued to Treasury, as an initial commitment fee, (1) one million shares of Variable Liquidation Preference Senior Preferred Stock, Series 2008-2, which we refer to as the “senior preferred stock,” and (2) a warrant to purchase, for a nominal price, shares of our common stock equal to 79.9% of the total number of shares of our common stock outstanding on a fully diluted basis at the time the warrant is exercised, which we refer to as the “warrant.” We did not receive any cash proceeds from Treasury as a result of issuing the senior preferred stock or the warrant.
 
Under the terms of the senior preferred stock, Treasury is entitled to a quarterly dividend of 10% per year (which increases to 12% per year if not paid timely and in cash) on the aggregate liquidation preference of the senior preferred stock. To the extent we are required to draw on Treasury’s funding commitment, the liquidation preference of the senior preferred stock will be increased by the amount of any funds we receive. The amounts payable for the senior preferred stock dividend could be substantial and have an adverse impact on our financial position and net worth. The senior preferred stock is senior in liquidation preference to our common stock and all other series of preferred stock. In addition, beginning on March 31, 2010, we are required to pay a quarterly commitment fee to Treasury, which fee will accrue from January 1, 2010. We are required to pay this fee each quarter for as long as the senior preferred stock purchase agreement is in effect, even if we do not request funds from Treasury under the agreement. The amount of this fee has not yet been determined.
 
The senior preferred stock purchase agreement includes significant restrictions on our ability to manage our business, including limiting the amount of indebtedness we can incur to 110% of our aggregate indebtedness as of June 30, 2008 and capping the size of our mortgage portfolio at $850 billion as of December 31, 2009. In addition, beginning in 2010, we must decrease the size of our mortgage portfolio at the rate of 10% per year until it reaches $250 billion. Depending on the pace of future mortgage liquidations, we may need to reduce or eliminate our purchases of mortgage assets or sell mortgage assets to achieve this reduction. In addition, while the senior preferred stock is outstanding, we are prohibited from paying dividends (other than on the senior preferred stock) or issuing equity securities without Treasury’s consent. The terms of the senior preferred stock purchase agreement and warrant make it unlikely that we will be able to obtain equity from private sources.
 
The senior preferred stock purchase agreement has an indefinite term and can terminate only in very limited circumstances, which do not include the end of the conservatorship. The agreement therefore could continue after the conservatorship ends. Treasury has the right to exercise the warrant, in whole or in part, at any time on or before September 7, 2028. As of November 7, 2008, we have not drawn any funds from Treasury pursuant to the senior preferred stock purchase agreement. We provide more detail about the provisions of the senior preferred stock purchase agreement, the senior preferred stock and the warrant, the limited circumstances under which those agreements terminate, and the limitations they place on our ability to manage our business under “Conservatorship and Treasury Agreements—Treasury Agreements” below. See “Part II—Item 1A—Risk Factors” for a discussion of how the restrictions under the senior preferred stock purchase agreement may have a material adverse effect on our business.
 
Treasury Credit Facility
 
On September 19, 2008, we entered into a lending agreement with Treasury pursuant to which Treasury established a new secured lending credit facility that is available to us until December 31, 2009 as a liquidity back-stop. We refer to this as the “Treasury credit facility.” In order to borrow pursuant to the Treasury credit facility, we are required to post collateral in the form of Fannie Mae MBS or Freddie Mac mortgage-backed securities to secure all borrowings under the facility. The terms of any borrowings under the credit facility, including the interest rate payable on the loan and the amount of collateral we will need to provide as security for the loan, will be determined by Treasury. Treasury is not obligated under the credit facility to make any loan to us.


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Treasury does not have authority to extend the term of this credit facility beyond December 31, 2009, which is when Treasury’s temporary authority to purchase our obligations and other securities, granted by the Regulatory Reform Act, expires. After December 31, 2009, Treasury may purchase up to $2.25 billion of our obligations under its permanent authority, as set forth in the Charter Act.
 
As of November 7, 2008, we have not borrowed any amounts under the Treasury credit facility. The terms of the Treasury credit facility are described in more detail in “Conservatorship and Treasury Agreements—Treasury Agreements.”
 
Changes in Company Management and our Board of Directors
 
Since our entry into conservatorship on September 6, 2008, ten members of our Board of Directors have resigned, including Stephen B. Ashley, our former Chairman of the Board. On September 16, 2008, the conservator appointed Philip A. Laskawy as the new non-executive Chairman of our Board of Directors. We currently have four members of our Board of Directors and nine vacancies.
 
As noted above, as our conservator, FHFA has assumed the powers of our Board of Directors. Accordingly, the current Board of Directors acts with neither the power nor the duty to manage, direct or oversee our business and affairs. The conservator has indicated that it intends to appoint a full Board of Directors to which it will delegate specified roles and responsibilities.
 
On September 7, 2008, the conservator appointed Herbert M. Allison, Jr. as our President and Chief Executive Officer, effective immediately.
 
Supervision of our Business under the Regulatory Reform Act and During Conservatorship
 
During the third quarter of 2008, we experienced a number of significant changes in our regulatory supervisory environment. First, on July 30, 2008, President Bush signed into law the Regulatory Reform Act, which placed us under the regulation of a new regulator, FHFA. That legislation strengthened the existing safety and soundness oversight of the GSEs and provided FHFA with new safety and soundness authority that is comparable to and in some respects broader than that of the federal bank agencies. That legislation gave FHFA enhanced powers that, even if we had not been placed into conservatorship, gave FHFA the authority to raise capital levels above statutory minimum levels, regulate the size and content of our portfolio, and approve new mortgage products. That legislation also gave FHFA the authority to place the GSEs into conservatorship or receivership under conditions set forth in the statute. Refer to “Legislation Relating to Our Regulatory Framework” in our Form 10-Q for the period ended June 30, 2008 for additional detail regarding the provisions of the Regulatory Reform Act and “Part II—Item 1A—Risk Factors” of this report for additional risks and information regarding this regulation, including the receivership provisions.
 
Second, we experienced a change in control when we were placed into conservatorship on September 6, 2008. Under conservatorship, we have additional heightened supervision and direction from our regulator, FHFA, which is also acting as our conservator.


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The table below presents a summary comparison of various features of our business before and after we were placed into conservatorship. Following this table, we provide additional information about a number of aspects of our business now that we are in conservatorship under “Managing Our Business During Conservatorship.”
 
             
Topic     Before Conservatorship     During Conservatorship
Authority of Board of Directors, management and stockholders    
•  Board of Directors with right to determine the general policies governing the operations of the corporation and exercise all power and authority of the company, except as vested in stockholders or as the Board chooses to delegate to management

•  Board of Directors delegated significant authority to management

•  Stockholders with specified voting rights
   
•  FHFA, as conservator, has all of the power and authority of the Board of Directors, management and the shareholders

•  The conservator has delegated authority to management to conduct day-to-day operations so that the company can continue to operate in the ordinary course of business. The conservator retains overall management authority, including the authority to withdraw its delegations to management at any time.

•  Stockholders have no voting rights
             
Regulatory Supervision
   
•  Regulated by FHFA, our new regulator created by the Regulatory Reform Act

•  Regulatory Reform Act gave regulator significant additional safety and soundness supervisory powers
   
•  Regulated by FHFA, with powers as provided by Regulatory Reform Act

•  Additional management authority by FHFA, which is serving as our conservator
             
Structure of Board of Directors
   
•  13 directors: 12 independent plus President and Chief Executive Officer; independent, non-executive Chairman of the Board

•  Eight separate Board committees, including Audit Committee in which four of the five independent members were “audit committee financial experts”
   
•  Currently four directors, consisting of a non-executive Chairman of the Board and three independent directors (who were also directors of Fannie Mae immediately prior to conservatorship), with neither the power nor the duty to manage, direct or oversee our business and affairs

•  No Board committees have members or authority to act

•  Conservator has indicated its intent to appoint a full Board of Directors to which it will delegate specified roles and responsibilities
             
Management
   
•  Daniel H. Mudd served as President and Chief Executive Officer from June 2005 to September 6, 2008
   
•  Herbert M. Allison, Jr. began serving as President and Chief Executive Officer on September 7, 2008
             
Capital
   
•  Statutory and regulatory capital requirements

•  Capital classifications as to adequacy of capital issued by FHFA on quarterly basis
   
•  Capital requirements not binding

•  Quarterly capital classifications by FHFA suspended
             


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Topic     Before Conservatorship     During Conservatorship
Net Worth1
   
•  Receivership mandatory if we have negative net worth for 60 days
   
•  Conservator has directed management to focus on maintaining positive stockholders’ equity1 in order to avoid both the need to request funds under the senior preferred stock purchase agreement and our mandatory receivership

•  Receivership mandatory if we have negative net worth for 60 days2
             
Managing for the Benefit of Shareholders    
•  Maximize shareholder value over the long term

•  Fulfill our mission of providing liquidity, stability and affordability to the mortgage market
   
•  No longer managed with a strategy to maximize common shareholder returns

•  Maintain positive net worth and fulfill our mission of providing liquidity, stability and affordability to the mortgage market

•  Focus on returning to long-term profitability if it does not adversely affect our ability to maintain positive net worth or fulfill our mission
             
 
 
1 Our “net worth” refers to our assets less our liabilities, as reflected on our GAAP balance sheet. If we have a negative net worth, then, if requested by the conservator (or by our Chief Financial Officer if we are not under conservatorship), Treasury is required to provide funds to us pursuant to the senior preferred stock purchase agreement. In addition, if we have a negative net worth for a period of 60 days, the Director of FHFA is required by the Regulatory Reform Act to place us in receivership. “Net worth” is substantially the same as “stockholders equity;” however, “net worth” also includes the minority interests that third parties own in our consolidated subsidiaries (which was $159 million as of September 30, 2008), which is excluded from stockholders’ equity.
 
2 Treasury’s funding commitment under the senior preferred stock purchase agreement is expected to enable us to maintain a positive net worth as long as Treasury has not yet invested the full $100 billion provided for in that agreement.
 
The conservatorship has no specified termination date. There can be no assurance as to when or how the conservatorship will be terminated, whether we will continue to exist following conservatorship, or what our business structure will be during or following our conservatorship. In a statement issued on September 7, 2008, the Secretary of the Treasury indicated that 2008 and 2009 should be viewed as a “time out” where we and Freddie Mac are stabilized while policymakers decide our future role and structure. He also stated that there is a consensus that we and Freddie Mac pose a systemic risk and that we cannot continue in our current form. For more information on the risks to our business relating to the conservatorship and uncertainties regarding the future of our business, see “Part II—Item 1A—Risk Factors.”
 
Managing Our Business During Conservatorship
 
Our Management
 
FHFA, in its role as conservator, has overall management authority over our business. During the conservatorship, the conservator has delegated authority to management to conduct day-to-day operations so that the company can continue to operate in the ordinary course of business. We can, and have continued to, enter into and enforce contracts with third parties. The conservator retains the authority to withdraw its delegations to us at any time. The conservator is working actively with management to address and determine the strategic direction for the enterprise, and in general has retained final decision-making authority in areas regarding: significant impacts on operational, market, reputational or credit risk; major accounting determinations, including policy changes; the creation of subsidiaries or affiliates and transacting with them; significant litigation; setting executive compensation; retention of external auditors; significant mergers and

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acquisitions; and any other matters the conservator believes are strategic or critical to the enterprise in order for the conservator to fulfill its obligations during conservatorship. See “Conservatorship and Treasury Agreements—Conservatorship—General Powers of the Conservator Under the Regulatory Reform Act” for more information.
 
Our Objectives
 
Based on the Federal National Mortgage Association Charter Act, or Charter Act, public statements from Treasury officials and guidance from our conservator, we have a variety of different, and potentially conflicting, objectives, including:
 
  •  providing liquidity, stability and affordability in the mortgage market;
 
  •  immediately providing additional assistance to the struggling housing and mortgage markets;
 
  •  maintaining a positive net worth and avoiding the need to draw funds from Treasury pursuant to the senior preferred stock purchase agreement;
 
  •  returning to long-term profitability; and
 
  •  protecting the interests of the taxpayers.
 
These objectives create conflicts in strategic and day-to-day decision making that will likely lead to less than optimal outcomes for one or more, or possibly all, of these objectives. For example, maintaining a positive net worth could require us to constrain some of our business activities, including activities that provide liquidity, stability and affordability to the mortgage market. Conversely, to the extent we increase or undertake new activities to assist the mortgage market, our financial results are likely to suffer, and we may be less able to maintain a positive net worth. We regularly consult with and receive direction from our conservator on how to balance these objectives. To the extent that we are unable to maintain a positive net worth, we will be required to obtain funding from Treasury under the senior preferred stock purchase agreement, which will increase our ongoing expenses and, therefore, extend the period of time until we might be able to return to profitability. These objectives also create risks that we discuss in “Part II—Item 1A—Risk Factors.”
 
Changes in Strategies to Meet New Objectives
 
Since September 6, 2008, we have made a number of changes in the strategies we use to manage our business in support of our new objectives outlined above. These include the changes we describe below.
 
Eliminating Planned Increase in Adverse Market Delivery Charge
 
As part of our efforts to increase liquidity in the mortgage market and make mortgage loans more affordable, we announced on October 2, 2008 that we were eliminating our previously announced 25 basis point increase in our adverse market delivery charge that was scheduled to take effect on November 1, 2008. The elimination of this charge will reduce our net income. We intend for our lenders to pass this savings on to borrowers in the form of lower mortgage costs. Whether this action will actually result in lower mortgage costs for borrowers, however, will depend on a variety of issues beyond our control, including whether or not lenders pass these savings on to borrowers, the overall level of credit that lenders are willing to extend to borrowers, the assessed riskiness of a particular borrower in the current market environment and other factors.
 
Increasing the Size of Our Mortgage Portfolio
 
Consistent with our ability under the senior preferred stock purchase agreement to increase the size of our mortgage portfolio through the end of 2009, FHFA has directed us to acquire and hold increased amounts of mortgage loans and mortgage-related securities in our mortgage portfolio to provide additional liquidity to the mortgage market. Our calculation of the mortgage portfolio, which has not been confirmed by Treasury, is our gross mortgage portfolio (defined as the unpaid principal balance of our mortgage loans and mortgage-related securities, excluding the effect of market valuation, premiums, discounts and impact of consolidations). As of September 30, 2008, our gross mortgage portfolio was $761.4 million. Our extremely limited ability to issue


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callable or long-term debt at this time (which is discussed in greater detail below) makes it difficult to increase the size of our mortgage portfolio. In addition, the covenant in the senior preferred stock purchase agreement prohibiting us from issuing debt in excess of 110% of our aggregate indebtedness as of June 30, 2008 likely will prohibit us from increasing the size of our mortgage portfolio to $850 billion, unless Treasury elects to amend or waive this limitation. Our calculation of our aggregate indebtedness as of June 30, 2008, which has not been confirmed by Treasury, set this debt limit at $892 billion. We calculate aggregate indebtedness as the unpaid principal balance of our debt outstanding, or in the case of long-term zero coupon bonds, at maturity and exclude basis adjustments and debt from consolidations. As of October 31, 2008, we estimate that our aggregate indebtedness totaled $880 billion. For a discussion of the limitations we are currently experiencing on our ability to issue debt securities, see “Liquidity,” “Liquidity and Capital Management—Liquidity” and “Part II—Item 1A—Risk Factors.”
 
Housing and Economic Conditions
 
The housing, mortgage and credit markets, as well as the general economy, have experienced significant challenges, which have driven our financial results. The housing market downturn that began in the third quarter of 2006, and continued through 2007, has significantly worsened in 2008. The market continues to experience declines in home sales, housing starts, mortgage originations and home prices, as well as increases in mortgage loan delinquencies, defaults and foreclosures. Growth in U.S. residential mortgage debt outstanding slowed to an estimated annual rate of 2.0% based on the first six months of 2008, compared with an estimated annual rate of 8.3% based on the first six months of 2007, and is expected to continue to decline to a growth rate of about 0% in 2009. We continue to expect that home prices will decline 7% to 9% on a national basis in 2008, and that home prices nationally will decline 15% to 19% from their peak in 2006 before they stabilize. Through September 30, 2008, home prices nationally have declined 10% from their peak in 2006. (Our estimates compare to approximately 12% to 16% for 2008, and 27% to 32% peak-to-trough, using the Case-Schiller index.) We currently expect home price declines at the top end of our estimated ranges. We also expect significant regional variation in these national home price decline percentages, with steeper declines in certain areas such as Florida, California, Nevada and Arizona. The deteriorating economic conditions and related government actions that occurred in the third quarter of 2008 have increased the uncertainty of future economic conditions, including home price movements. Therefore, while our peak-to-trough home price forecast is at the top end of the 15% to 19% range, there is increasing uncertainty about the actual amount of decline that will occur.
 
The continuing downturn in the housing and mortgage markets has been affected by, and has had an effect on, challenging conditions that existed across the global financial markets. This adverse market environment intensified towards the end of the quarter, particularly in September, and into October, and was characterized by increased illiquidity in the credit markets, wider credit spreads, lower business and consumer confidence, and concerns about corporate earnings and the solvency of many financial institutions. Conditions in the financial services industry were particularly difficult. In September 2008, we and Freddie Mac were placed into conservatorship, Lehman Brothers Holdings Inc. (referred to as Lehman Brothers) filed for bankruptcy, and a number of major U.S. financial institutions consolidated or received financial assistance from the U.S. government.
 
Real gross domestic product, or GDP, growth was − 0.3% in the third quarter of 2008. The unemployment rate at the end of the third quarter of 2008 increased to 6.1% from 5.0% at the end of 2007, the highest level since 2003. In the equity markets, the Dow Jones Industrial Average, the S&P 500 Index and the NASDAQ Composite Index decreased on average by 9%, 9% and 6%, respectively, during the third quarter of 2008. In October 2008, the Dow Jones Industrial Average, the S&P 500 and the NASDAQ Composite Index decreased on average by 14%, 17% and 18%, respectively.
 
In September 2008, Treasury proposed a plan to buy mortgage-related, illiquid and other troubled assets from U.S. financial institutions. Also in September 2008, the Federal Reserve announced enhancements to its programs to provide additional liquidity to the asset-backed commercial paper and money markets, including plans to purchase from primary dealers short-term debt obligations issued by us, Freddie Mac and the Federal Home Loan Banks. As an additional response to the still worsening credit conditions, the U.S. government and


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other world governments took a number of actions. In early October 2008, the Emergency Economic Stabilization Act of 2008 was enacted, and the Federal Reserve announced that it would establish a commercial paper funding facility in order to provide additional liquidity to the short-term debt markets. Also, in October 2008, the Federal Reserve and other central banks lowered interest rates in a coordinated action.
 
On October 14, 2008, the U.S. government announced a series of initiatives to strengthen market stability, improve the strength of financial institutions, and enhance market liquidity. Treasury announced a capital purchase program in which eligible financial institutions would sell preferred shares to the U.S. government. Under the program, Treasury will purchase up to $250 billion of senior preferred shares on standardized terms. As of November 1, 2008, Treasury had invested $125 billion in nine large financial institutions under this program. In addition, the Federal Deposit Insurance Corporation, or FDIC, announced a temporary liquidity guarantee program pursuant to which it will guarantee, until June 30, 2012, the senior debt issued on or before June 30, 2009 by all FDIC-insured institutions and their holding companies, as well as deposits in non-interest-bearing accounts held in FDIC-insured institutions. Also, the Federal Reserve announced that its commercial paper funding facility program will fund purchases of commercial paper of three-month maturity from high-quality issuers in an effort to provide additional liquidity to the short-term debt markets.
 
Summary of Our Financial Results for the Third Quarter of 2008
 
The challenges experienced in the housing, mortgage and financial markets throughout 2008 continued to increase significantly during the third quarter of 2008. We experienced a change in control when we were placed into conservatorship on September 6, 2008.
 
Both prior to and after initiation of the conservatorship in the third quarter of 2008, our results continued to be adversely affected by conditions in the housing market. In addition, we recorded a significant non-cash charge of $21.4 billion during the third quarter of 2008 to establish a deferred tax asset valuation allowance, which contributed to a net loss of $29.0 billion and a diluted loss per share of $13.00 for the third quarter of 2008, compared with a net loss of $2.3 billion and a diluted loss per share of $2.54 for the second quarter of 2008. We recorded a net loss of $1.4 billion and diluted loss per share of $1.56 for the third quarter of 2007. The $26.7 billion increase in our net loss for the third quarter of 2008 compared with the second quarter of 2008 was driven principally by our establishment of a deferred tax asset valuation allowance, as well as an increase in fair value losses, credit-related expenses, and investment losses from other-than-temporary impairment. We have recorded a net loss in each of the first three quarters of 2008, for a total net loss of $33.5 billion and a diluted loss per share of $24.24 for the nine months ended September 30, 2008, compared with net income of $1.5 billion and diluted earnings per share of $1.17 for the nine months ended September 30, 2007.
 
We determined it was necessary to establish a valuation allowance against our deferred tax assets due to the rapid deterioration of market conditions discussed above, the uncertainty of future market conditions on our results of operations and the uncertainty surrounding our future business model as a result of our placement into conservatorship by FHFA on September 6, 2008. This charge reduced our net deferred tax assets to $4.6 billion as of September 30, 2008, from $20.6 billion as of June 30, 2008.
 
Our mortgage credit book of business increased to $3.1 trillion as of September 30, 2008 from $2.9 trillion as of December 31, 2007, as we have continued to perform our chartered mission of helping provide liquidity to the mortgage markets. Our estimated market share of new single-family mortgage-related securities issuances was an estimated 42.2% for the third quarter of 2008, compared with an estimated 45.4% for the second quarter of 2008 and 50.1% for the first quarter of 2008. Our estimated market share of new single-family mortgage-related securities issuances decreased from levels during the first and second quarters of 2008 primarily due to changes in our pricing and eligibility standards, which reduced our acquisition of higher risk loans, as well as changes in the eligibility standards of the mortgage insurance companies, which further reduced our acquisition of loans with high loan-to-value ratios. The cumulative effect of these changes reduced our acquisitions in the period.
 
We provide more detailed discussions of key factors affecting changes in our results of operations and financial condition in “Consolidated Results of Operations,” “Business Segment Results,” “Consolidated Balance Sheet Analysis,” “Supplemental Non-GAAP Information—Fair Value Balance Sheets,” and “Risk


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Management—Credit Risk Management—Mortgage Credit Risk Management—Mortgage Credit Book of Business.”
 
Net Worth
 
As a result of our net loss for the nine months ended September 30, 2008, our net worth (defined as the amount by which our total assets exceeded our total liabilities, as reflected on our GAAP balance sheet) has decreased to $9.4 billion as of September 30, 2008 from $44.1 billion as of December 31, 2007. Moreover, $4.6 billion of our net worth as of September 30, 2008 consisted of our remaining deferred tax assets, which could be subject to an additional valuation allowance in the future. In addition, the widening of spreads that occurred in October 2008 resulted in mark-to-market losses on our investment securities that have decreased our net worth since September 30, 2008.
 
Under the Regulatory Reform Act, FHFA must place us into receivership if our assets are less than our obligations for a period of 60 days. If current trends in the housing and financial markets continue or worsen, and we have a significant net loss in the fourth quarter of 2008, we may have a negative net worth as of December 31, 2008. If this were to occur, we would be required to obtain funding from Treasury pursuant to its commitment under the senior preferred stock purchase agreement in order to avoid a mandatory trigger of receivership under the Regulatory Reform Act.
 
Liquidity
 
We fund our purchases of mortgage loans primarily from the proceeds from sales of our debt securities. In September 2008, Treasury made available to us two additional sources of funding: the Treasury credit facility and the senior preferred stock purchase agreement, as described below under “Conservatorship and Treasury Agreements—Treasury Agreements.”
 
Since early July 2008, we have experienced significant deterioration in our access to the unsecured debt markets, particularly for long-term debt, and in the yields on our debt as compared to relevant market benchmarks. Although we experienced a slight stabilization in our access to the short-term debt markets immediately following our entry into conservatorship in early September, we experienced renewed deterioration in our access to the short-term debt markets following the initial improvement. Beginning in October, consistent demand for our debt securities has decreased even further, particularly for our long-term debt and callable debt, and the interest rates we must pay on our new issuances of short-term debt securities have increased. Although we experienced a reduction in LIBOR rates in late October and early November, and as a result we have begun to see some improvement in our short-term debt yields, the recent improvement may not continue or may reverse. We have experienced reduced demand for our debt obligations from some of our historical sources of that demand, particularly in international markets.
 
There are several factors contributing to the reduced demand for our debt securities, including continued severe market disruptions, market concerns about our capital position and the future of our business (including its future profitability, future structure, regulatory actions and agency status) and the extent of U.S. government support for our business. In addition, on October 14, 2008, the Secretary of the Treasury, the Chairman of the Federal Reserve Board and the Chairman of the FDIC announced that the FDIC will guarantee until June 30, 2012 new senior unsecured debt issued on or before June 30, 2009 by all FDIC-insured institutions and their holding companies. The U.S. government does not guarantee, directly or indirectly, our securities or other obligations. It should be noted that, as described above, pursuant to the Housing and Economic Recovery Act of 2008, Congress authorized Treasury to purchase our debt, equity and other securities, which authority Treasury used to make its commitment under the senior preferred stock purchase agreement to provide up to $100 billion in funds as needed to help us maintain a positive net worth (which means that our total assets exceed our total liabilities, as reflected on our GAAP balance sheet) and made available to us the Treasury credit facility. In addition, the U.S. government guarantee of competing obligations means that those obligations receive a more favorable risk weighting than our securities under bank and thrift risk-based capital rules, and therefore may make them more attractive investments than our debt securities. Moreover, to the extent the market for our debt securities has improved due to the availability


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of the Treasury credit facility, our “roll over” risk may increase in anticipation of the expiration of the credit facility on December 31, 2009.
 
As noted above, we currently have limited ability to issue debt securities with maturities greater than one year. Although we typically sell one or more fixed-rate issues of our Benchmark® Notes with a minimum issue size of $3.0 billion each month, we announced on October 20, 2008 that we would not issue Benchmark® Notes in October. We have, therefore, relied increasingly on short-term debt to fund our purchases of mortgage loans, which are by nature long-term assets. As a result, we are required to refinance, or “roll over,” our debt on a more frequent basis, exposing us to an increased risk of insufficient demand, increasing interest rates and adverse credit market conditions. See “Liquidity and Capital Management—Liquidity—Funding—Debt Funding Activity” for more information on our debt funding activities and risks posed by our current market challenges and “Part II—Item 1A—Risk Factors” for a discussion of the risks to our business posed by our reliance on the issuance of debt to fund our operations. In addition, our increasing reliance on short-term debt and limited ability to issue callable debt, combined with limitations on the availability of a sufficient volume of reasonably priced derivative instruments to hedge our short-term debt position, has had an adverse impact on our duration and interest rate risk management activities. See “Risk Management—Interest Rate Risk Management and Other Market Risks” for more information regarding our interest rate risk management activities.
 
The Treasury credit facility and the senior preferred stock purchase agreement may provide additional sources of funding in the event that we cannot adequately access the unsecured debt markets. Our access to the Treasury credit facility is subject to Treasury’s agreement to make funds available pursuant to that facility, and amounts available to us under the facility are limited by the amount of collateral we are able to supply to secure the loan. As of September 30, 2008, we had approximately $190 billion in unpaid principal balance of Fannie Mae MBS and Freddie Mac mortgage-backed securities available as collateral to secure loans under the Treasury credit facility. We believe the fair market value of these Fannie Mae MBS and Freddie Mac mortgage-backed securities is less than the current unpaid principal balance of these securities. The Federal Reserve Bank of New York (referred to as FRBNY), as collateral valuation agent for Treasury, has discretion to value these securities as it considers appropriate, and we believe would apply a “haircut” reducing the value it assigns to these securities from their current unpaid principal balance in order to reflect its determination of the current fair market value of the collateral. Accordingly, the amount that we could borrow under the credit facility using those securities as collateral would be less than $190 billion. We also hold whole loans in our mortgage portfolio, and a portion of these whole loans could potentially be securitized into Fannie Mae MBS and then pledged as collateral under the credit facility; however, as described in “Liquidity and Capital Management—Liquidity—Liquidity Risk Management—Liquidity Contingency Plan,” we currently face technological and operational limitations on our ability to securitize these loans. There can be no assurance as to the value that FRBNY would assign to the collateral we provide under the credit facility, or that our collateral would continue to maintain that value at the time of any actual use of the credit facility. If we were to pledge the collateral under the Treasury credit facility, we would be restricted in our ability to pledge collateral for other secured lending transactions. Further, unless amended or waived by Treasury, the amount we may borrow under the credit facility is limited by the restriction under the senior preferred stock purchase agreement on incurring debt in excess of 110% of our aggregate indebtedness as of June 30, 2008.
 
An additional source of funds is the senior preferred stock purchase agreement, but Treasury has committed to provide funds to us under the agreement only to the extent that we have a negative net worth (specifically, if our total liabilities exceed our total assets, as reflected on our GAAP balance sheet). As a result of these terms and structures of the arrangements with Treasury, the amounts that we may draw under the Treasury credit facility and the senior preferred stock purchase agreement together may prove insufficient to allow us either to roll over our existing debt at the time we need to do so or to continue to fulfill our mission of providing liquidity to the mortgage market at appropriate levels. See “Liquidity and Capital Management—Liquidity” and “Part II—Item 1A—Risk Factors” for additional information regarding our liquidity position and the risks to our business relating to our liquidity position.
 
To the extent that we are unable to access the debt markets, we may be able to rely on alternative sources of liquidity in the marketplace as outlined in our liquidity contingency plan. In the current market environment,


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however, we have significant uncertainty regarding our ability to execute on our liquidity contingency plan. See “Liquidity and Capital Management—Liquidity—Liquidity Risk Management—Liquidity Contingency Plan” for a description of our liquidity contingency plan and the current uncertainties regarding that plan.
 
Managing Problem Mortgage Loans and Preventing Foreclosures
 
We expect economic conditions and falling home prices to continue to negatively affect our credit performance in 2008 and 2009, which will cause our credit losses to increase. Further, if economic conditions continue to decline and the unemployment rate continues to rise, more borrowers will be unable to make their monthly mortgage payments, which would lead to higher defaults, foreclosures, sharper declines in home prices and higher credit losses.
 
Approximately 92% of our guaranty book of business is made up of single-family conventional mortgage loans that we own or that back Fannie Mae MBS. Therefore, most of our credit loss reduction and foreclosure prevention efforts are focused on our single-family conventional loans, both those we hold in our mortgage portfolio and those we guarantee.
 
As of September 30, 2008, our total nonperforming loans were $63.6 billion, or 2.2% of our total guaranty book of business, compared with $46.1 billion, or 1.6%, as of June 30, 2008, and $35.8 billion, or 1.3%, as of December 31, 2007. Our total nonperforming assets, which consist of nonperforming loans together with our inventory of foreclosed properties, were $71.0 billion, or 2.4% of our total guaranty book of business and foreclosed properties, compared with nonperforming assets of $52.0 billion, or 1.8%, as of June 30, 2008, and $39.3 billion, or 1.4%, as of December 31, 2007. While it is expected that our nonperforming assets will increase in 2008 and 2009, our credit management actions are designed to prevent the number of our nonperforming assets from being higher than they otherwise would be and to reduce the number of our nonperforming assets over time.
 
Other key measures of how well we manage our credit losses are our single-family foreclosure rate and our inventory of single-family foreclosed properties. Our single-family foreclosure rate was 0.16% in the third quarter of 2008, compared with 0.13% in the second quarter of 2008, and 0.07% in the third quarter of 2007. Our inventory of single-family foreclosed properties was 67,519 as of September 30, 2008, compared with 54,173 as of June 30, 2008 and 33,729 as of December 31, 2007.
 
In light of the continued deterioration in our credit performance, we have been, and are continuing, to take steps designed to control, and ultimately reduce, the number of our foreclosures and our credit losses. During the third quarter of 2008, we initiated or enhanced a number of the tools that we use to manage our credit losses.
 
  •  Workouts of Delinquent Loans.  We increased our foreclosure prevention workouts from an average of approximately 7,000 per month during the period from January through May 2008, to an average of approximately 14,000 per month during the period from June to September 2008. We are using a variety of tools to address the need for more workouts as the number of our delinquent loans rises. During the period from January 2007 through September 2008, we helped nearly 300,000 homeowners avoid foreclosure through workouts and refinancing. We helped approximately 131,000 of these homeowners avoid foreclosure through workouts by, among other means, creating repayment plans, providing HomeSaver Advance bridge loans, reducing interest rates, extending loan terms or other workouts to assist struggling borrowers. Information about our refinancing assistance is discussed below under “Supporting Borrowers and Mortgage Market Liquidity.”
 
  —  HomeSaver Advancetm.  One of the workout tools we implemented in 2008 is HomeSaver Advance, an unsecured, personal loan designed to help a borrower after a temporary financial difficulty to bring a delinquent mortgage loan current. We began purchasing HomeSaver Advance loans in the first quarter of 2008 and have since purchased more than 45,000 of these loans.
 
  —  Outreach to Delinquent Borrowers.  We have expanded our use of techniques to contact borrowers who have missed payments, even as early as after one missed payment. These techniques include


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  targeted mass mailings to borrowers with loans considered high risk and the use of specialty servicers with experience in contacting and working with high-risk borrowers.
 
  —  Review of Foreclosure Referrals.  We recently began an initiative in which we review loans headed on a path to foreclosure in an effort to keep borrowers in their homes and to help us avoid the increased credit losses associated with foreclosures. Our objective is to provide this review, which we call a “Second Look,” to every owner-occupied property prior to foreclosure.
 
  •  Servicer Management.  We have made changes to how we oversee mortgage servicers to streamline the workout process and provide additional incentives for workout performance. We delegate many loss mitigation decisions to our servicers so that they are able to react more quickly to the needs of delinquent borrowers, and we have implemented a number of operational changes requested by servicers to help them work more effectively with borrowers. We have increased the incentive fees we pay to servicers to conduct workouts, and expanded the deployment of our personnel and contractors inside the offices of our largest mortgage servicers to make sure our workout guidelines are followed. We continue working with our servicers to find ways to enhance our workout protocols and our servicers’ work flow processes.
 
  •  Review of Defaulted Loans.  In 2008, we continued performing loan reviews in cases where we believe we have incurred a loss or could incur a loss due to fraud or improper lending practices and we have increased our efforts to pursue recoveries from mortgage lenders related to these loans, including demanding that lenders repurchase the loans from us pursuant to their contractual obligations.
 
  •  REO Inventory Management.  As our foreclosure rates have increased and home sales have declined, our inventory of foreclosed properties we own has increased. We refer to these properties as real estate owned, or REO, properties. We have expanded both our internal REO inventory management capabilities and the network of firms that assist us with property dispositions.
 
  •  Underwriting Changes.  We have continued to review and revise our underwriting and eligibility standards, including changes implemented through our most recent release of DesktopUnderwriter® , our proprietary underwriting system, to reduce our exposure to the current risks in the housing market. The revisions we have implemented have resulted in a significant reduction in our acquisition of loan types that currently represent a majority of our credit losses, especially Alt-A loans. Additional revisions become effective in December 2008 and January 2009. Effective January 1, 2009, we are discontinuing the purchase of newly originated Alt-A loans; we are currently purchasing only a very small number of these loans in order to allow our lenders to deliver loans already in the pipeline when we announced our decision to terminate Alt-A purchases. We may continue to purchase Alt-A loans that are not newly originated and that meet acceptable eligibility and underwriting guidelines. We and the conservator continue to review our underwriting and eligibility standards and may in the future make additional changes as necessary to reflect future changes in the market and to fulfill our mission to expand the availability and affordability of mortgage credit.
 
For a further description of our management of mortgage credit risk, refer to “Consolidated Results of Operations—Credit-Related Expenses” and “Risk Management—Credit Risk Management—Mortgage Credit Risk Management.” Actions that we are taking to manage problem loans and prevent foreclosures may increase our expenses and may not be effective in reducing our credit losses, as described in “Part II—Item 1A—Risk Factors.”
 
Supporting Borrowers and Mortgage Market Liquidity
 
We are continually working to fulfill our mission of providing liquidity, stability and affordability to the housing and mortgage markets. Recent economic conditions and the mortgage market downturn have made it more important than ever that we fulfill our mission by supporting borrowers struggling to pay their mortgages, helping new borrowers obtain mortgage loans, and providing liquidity, stability and affordability to the housing and mortgage markets for the long term.


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Supporting Borrowers
 
To support struggling borrowers and help new borrowers obtain mortgage loans, in addition to the measures discussed above, we use a variety of additional strategies, which include:
 
  •  Refinancing Assistance.  Since 2007, we have been focusing on helping homeowners refinance into loans designed to help them keep their homes in the long term, such as loans with fixed rates and loans with lower monthly payments due to lower interest rates and/or longer terms. Part of this effort includes helping borrowers with subprime loans refinance with fixed-rate prime mortgages. Since January 2007, we have refinanced nearly 169,000 subprime loans.
 
  •  Support for Borrower Counseling Efforts.  We contribute to programs, such as the Hope Hotline, that offer counseling to borrowers to help them develop a plan that will enable them to remain in their homes. During the period from January 2007 through September 2008, we committed nearly $12 million in grants to support borrower counseling efforts, including mailings, telethons, foreclosure prevention workshops and housing fairs.
 
  •  Cancellation of Planned Delivery Fee Increase.  As discussed above, in October 2008, we canceled a planned 25 basis point increase in our adverse market delivery charge on mortgage loans.
 
  •  Increased financing of jumbo-conforming loans.  We increased our financing of jumbo-conforming loans by nearly 40%, from $2.3 billion to $3.2 billion, between August and September 2008. These are loans for homes in high-cost metropolitan areas, and they have higher principal balances than we would be permitted to purchase or guarantee if the homes were not in those areas.
 
We are working with the conservator to develop and deliver further solutions to help borrowers avoid foreclosure.
 
Providing Mortgage Market Liquidity
 
In addition to our borrower support efforts, our work to support lenders and provide mortgage market liquidity includes the following.
 
  •  Ongoing provision of liquidity to the mortgage markets.  In September, we purchased or guaranteed an estimated $44.1 billion in new business, measured by unpaid principal balance, consisting primarily of single-family mortgages, compared with $40.5 billion in August. We helped to finance 200,000 single-family homes in September. During the first nine months of 2008, we purchased approximately $28.6 billion of new and existing multifamily loans, helping to finance 480,000 units of rental housing.
 
  •  Partnership with Federal Home Loan Bank of Chicago.  On October 7, 2008, we announced that we had entered into an agreement with the Federal Home Loan Bank of Chicago under which we have committed to purchase 15-year and 30-year fixed-rate mortgage loans that the bank has acquired from its member institutions through its Mortgage Partnership Finance® (MPF®) program, which helps make affordable mortgages available to working families across the country. This arrangement is designed to allow us to expand our service to a broader market and provide additional liquidity to the mortgage market while prudently managing risk.
 
  •  Reduced fees for our real estate mortgage investment conduits, or REMICs.  In September 2008, we reduced the fees for our real estate mortgage investment conduits, or REMICs, by 15%.
 
  •  Multifamily rate lock commitment.  In the last six months, we introduced a streamlined rate lock commitment for multifamily lenders that allows them to lock in the rate that they will charge a borrower for a loan at any point during the underwriting process.
 
  •  Relaxing restrictions on institutions holding principal and interest payments on our behalf in response to FDIC rule change.  In October 2008, the FDIC announced a rule change that lowered our risk of suffering losses if a party holding principal and interest payments on our behalf in custodial depository accounts failed. In response to this rule change, we have reviewed and curtailed or reversed certain actions we had taken in recent months to reduce our risk, including reducing the amount of our funds permitted to be held with mortgage servicers, requiring more frequent remittances of funds and moving funds held with our largest counterparties from custodial accounts to trust accounts.


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Outlook
 
The expansion of the mortgage turmoil into the credit crisis that began in 2007 has continued and worsened through October 2008 and, combined with the commencement of the conservatorship and entry into the Treasury agreements in September 2008, have materially impacted our outlook for the remainder of 2008 and 2009. We expect that the current crisis in the U.S. and global financial markets will continue to adversely affect our financial results through the remainder of 2008 and 2009. Given our increasing uncertainty about the future, we are no longer able to have expectations with respect to certain matters.
 
Overall Market Conditions:  We expect that the current crisis in the U.S. and global financial markets will continue. We expect the unemployment rate to continue to increase as the economic slowdown continues. We expect to continue to experience home price declines and rising default and severity rates, all of which may worsen as unemployment rates continue to increase and if the U.S. experiences a broad-based recession. We expect growth in mortgage debt outstanding to continue to decline to a growth rate of about 0% in 2009. We continue to expect the level of foreclosures and single-family delinquency rates to continue to increase further through the end of 2008, and still further in 2009.
 
Home Price Declines:  We continue to expect that home prices will decline 7% to 9% on a national basis in 2008, and that we will experience a peak-to-trough home price decline of 15% to 19%. Through September 30, 2008, home prices nationally have declined 10% from their peak in 2006. (Our estimates compare to approximately 12% to 16% for 2008, and 27% to 32% peak-to-trough, using the Case-Schiller index.) We currently expect home price declines at the top end of our estimated ranges. We also expect significant regional variation in these national home price decline percentages, with steeper declines in certain areas such as Florida, California, Nevada and Arizona. The deteriorating economic conditions and related government actions that occurred in the third quarter have increased the uncertainty of future economic conditions, including home price movements. Therefore, while our peak-to-trough home price forecast is at the top end of the 15% to 19% range, there is increasing uncertainty about the actual amount of decline that will occur.
 
Credit Losses and Loss Reserves:  We continue to expect our credit loss ratio (which excludes SOP 03-3 and HomeSaver Advance fair value losses) to be between 23 and 26 basis points in 2008, partially due to a shift in credit losses from 2008 into 2009 as a result of certain foreclosure delays occurring in particular regions of the country and deployment of loss mitigation strategies that have the effect of lengthening the foreclosure pipeline. We continue to expect our credit loss ratio will increase further in 2009 compared with 2008. We expect significant continued increase in our combined loss reserves through the remainder of 2008 and further increases to continue in 2009.
 
Liquidity:  In the absence of action by Treasury to increase the level of support Treasury provides for our debt, we expect continued significant pressure on our access to the short-term debt markets and extremely limited access to the long-term debt markets at economically reasonable rates, both of which will significantly increase our borrowing costs, increase our “roll over” risk, limit our ability to grow, limit our ability to effectively manage our market and liquidity risk and increase the likelihood that we may need to borrow under the Treasury credit facility.
 
Uncertainty Regarding our Future Status and Profitability:  We expect that we will continue to face pressure, and are likely to experience adverse economic effects, from the strategic and day-to-day conflicts among our competing objectives. We are also likely to experience adverse economic effects from activities we may undertake to support the mortgage market and help borrowers. We expect that we will continue to face substantial uncertainty as to our future business strategy, business purpose and fundamental business structure.
 
Because of the current state of the market and the fact that we are in conservatorship, we no longer are able to provide guidance with respect to the growth of our guaranty book of business, growth in our guaranty fee income, the net interest yield we expect to achieve, or the portion of our credit-related expenses we expect to recognize by the end of 2008.


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SELECTED FINANCIAL DATA
 
The selected financial data presented below is summarized from our condensed consolidated results of operations for the three and nine months ended September 30, 2008 and 2007, as well as from our condensed consolidated balance sheets as of September 30, 2008 and December 31, 2007. This data should be read in conjunction with this MD&A, as well as with the unaudited condensed consolidated financial statements and related notes included in this report and with our audited consolidated financial statements and related notes included in our 2007 Form 10-K.
 
                                 
    For the
    For the
 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2008     2007(1)     2008     2007(1)  
    (In millions, except per share amounts)  
 
Statement of operations data:
                               
Net interest income
  $ 2,355     $ 1,058     $ 6,102     $ 3,445  
Guaranty fee income
    1,475       1,232       4,835       3,450  
Losses on certain guaranty contracts
          (294 )           (1,038 )
Trust management income
    65       146       247       460  
Fair value losses, net(2)
    (3,947 )     (2,082 )     (7,807 )     (1,224 )
Other income (expenses), net(3)
    (2,024 )     (58 )     (3,083 )     339  
Credit-related expenses(4)
    (9,241 )     (1,200 )     (17,833 )     (2,039 )
(Provision) benefit for federal income taxes
    (17,011 )     582       (13,607 )     468  
Net income (loss)
    (28,994 )     (1,399 )     (33,480 )     1,509  
Preferred stock dividends and issuance costs at redemption(5)
    (419 )     (119 )     (1,044 )     (372 )
Net income (loss) available to common stockholders(5)
    (29,413 )     (1,518 )     (34,524 )     1,137  
                                 
Per common share data:
                               
Earnings (loss) per share:
                               
Basic
  $ (13.00 )   $ (1.56 )   $ (24.24 )   $ 1.17  
Diluted
    (13.00 )     (1.56 )     (24.24 )     1.17  
Weighted-average common shares outstanding:
                               
Basic(6)
    2,262       974       1,424       973  
Diluted
    2,262       974       1,424       975  
Cash dividends declared per common share
  $ 0.05     $ 0.50     $ 0.75     $ 1.40  
                                 
New business acquisition data:
                               
Fannie Mae MBS issues acquired by third parties(7)
  $ 80,547     $ 148,320     $ 373,980     $ 407,962  
Mortgage portfolio purchases(8)
    46,400       49,574       144,070       134,407  
                                 
New business acquisitions
  $ 126,947     $ 197,894     $ 518,050     $ 542,369  
                                 
 


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    As of  
    September 30,
    December 31,
 
    2008     2007(1)  
    (Dollars in millions)  
 
Balance sheet data:
               
Investments in securities:
               
Trading
  $ 98,671     $ 63,956  
Available-for-sale
    262,054       293,557  
Mortgage loans:
               
Loans held for sale
    7,908       7,008  
Loans held for investment, net of allowance
    397,834       396,516  
Total assets
    896,615       879,389  
Short-term debt
    280,382       234,160  
Long-term debt
    550,928       562,139  
Total liabilities
    887,180       835,271  
Senior preferred stock
    1,000        
Preferred stock
    21,725       16,913  
Total stockholders’ equity
    9,276       44,011  
                 
Regulatory data:
               
Net worth(9)
    9,435       44,118  
                 
Book of business data:
               
Mortgage portfolio(10)
  $ 767,166     $ 727,903  
Fannie Mae MBS held by third parties(11)
    2,278,170       2,118,909  
Other guarantees(12)
    32,190       41,588  
                 
Mortgage credit book of business(13)
  $ 3,077,526     $ 2,888,400  
                 
Guaranty book of business(14)
  $ 2,941,116     $ 2,744,237  
                 
                 
Credit quality:
               
Nonperforming loans
  $ 63,648     $ 35,808  
Combined loss reserves
    15,605       3,391  
Combined loss reserves as a percentage of total guaranty book of business
    0.53 %     0.12 %
Combined loss reserves as a percentage of total nonperforming loans
    24.52       9.47  
 
                                 
    For the
  For the
    Three Months Ended
  Nine Months Ended
    September 30,   September 30,
    2008   2007(1)   2008   2007(1)
 
Performance ratios:
                               
Net interest yield(16)
    1 .10%     0 .52%     0 .98%     0 .57%
Average effective guaranty fee rate (in basis points)(17)
    23 .6 bp     22 .8 bp     26 .4 bp     22 .0 bp
Credit loss ratio (in basis points)(18)
    29 .7 bp     5 .3 bp     20 .1 bp     4 .3 bp
Return on assets(15)(19)
    (13 .20)%     (0 .72)%     (5 .18)%     0 .18%
Return on equity(15)(20)
      N/A       (1 9.4)         N/A       4 .8
Equity to assets(15)(21)
    2 .8     4 .7     3 .0     4 .8
 
 
  (1) Certain prior period amounts have been reclassified to conform to the current period presentation.
 
  (2) Consists of the following: (a) derivatives fair value gains (losses), net; (b) trading securities gains (losses), net; (c) hedged mortgage assets gains (losses), net; (d) debt foreign exchange gains (losses), net; and (e) debt fair value gains (losses), net.
 
  (3) Consists of the following: (a) investment gains (losses), net; (b) debt extinguishment gains (losses), net; (c) losses from partnership investments; and (d) fee and other income.
 
  (4) Consists of provision for credit losses and foreclosed property expense.

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  (5) Amounts for the three and nine months ended September 30, 2008 include approximately $6 million of dividends accumulated, but undeclared, for the reporting period on our outstanding cumulative senior preferred stock.
 
  (6) Amounts for the three and nine months ended September 30, 2008 include the weighted-average shares of common stock that would be issuable upon the full exercise of the warrant issued to Treasury from the date of conservatorship through the end of the reporting period. Because the warrant’s exercise price of $0.00001 per share is considered non-substantive (compared to the market price of our common stock), the warrant was evaluated based on its substance over form. It was determined to have characteristics of non-voting common stock, and thus included in the computation of basic earnings (loss) per share.
 
  (7) Unpaid principal balance of Fannie Mae MBS issued and guaranteed by us during the reporting period less: (a) securitizations of mortgage loans held in our portfolio during the reporting period and (b) Fannie Mae MBS purchased for our investment portfolio during the reporting period.
 
  (8) Unpaid principal balance of mortgage loans and mortgage-related securities we purchased for our investment portfolio during the reporting period. Includes acquisition of mortgage-related securities accounted for as the extinguishment of debt because the entity underlying the mortgage-related securities has been consolidated in our condensed consolidated balance sheet and includes capitalized interest.
 
  (9) Total assets less total liabilities.
 
(10) Unpaid principal balance of mortgage loans and mortgage-related securities (including Fannie Mae MBS) held in our portfolio.
 
(11) Unpaid principal balance of Fannie Mae MBS held by third-party investors. The principal balance of resecuritized Fannie Mae MBS is included only once in the reported amount.
 
(12) Includes primarily long-term standby commitments we have issued and single-family and multifamily credit enhancements that we have provided and that are not otherwise reflected in the table.
 
(13) Unpaid principal balance of: (1) mortgage loans held in our mortgage portfolio; (2) Fannie Mae MBS held in our mortgage portfolio; (3) non-Fannie Mae mortgage-related securities held in our investment portfolio; (4) Fannie Mae MBS held by third parties; and (5) other credit enhancements that we provide on mortgage assets. The principal balance of resecuritized Fannie Mae MBS is included only once in the reported amount.
 
(14) Unpaid principal balance of: (1) mortgage loans held in our mortgage portfolio; (2) Fannie Mae MBS held in our mortgage portfolio; (3) Fannie Mae MBS held by third parties; and (4) other credit enhancements that we provide on mortgage assets. Excludes non-Fannie Mae mortgage-related securities held in our investment portfolio for which we do not provide a guaranty. The principal balance of resecuritized Fannie Mae MBS is included only once in the reported amount.
 
(15) Average balances for purposes of the ratio calculations are based on beginning and end of period balances.
 
(16) Annualized net interest income for the period divided by the average balance of total interest-earning assets during the period.
 
(17) Annualized guaranty fee income as a percentage of average outstanding Fannie Mae MBS and other guarantees during the period.
 
(18) Annualized (a) charge-offs, net of recoveries and (b) foreclosed property expense, as a percentage of the average guaranty book of business during the period. We exclude from our credit loss ratio any initial losses recorded on delinquent loans purchased from MBS trusts pursuant to Statement of Position No. 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer (“SOP 03-3”), when the purchase price of seriously delinquent loans that we purchase from Fannie Mae MBS trusts exceeds the fair value of the loans at the time of purchase. Also excludes the difference between the unpaid principal balance of HomeSaver Advance loans at origination and the estimated fair value of these loans. Our credit loss ratio including the effect of these initial losses recorded pursuant to SOP 03-3 and related to HomeSaver Advance loans was 35.1 basis points and 14.9 basis points for the three months ended months September 30, 2008 and 2007, respectively, and 26.3 basis points and 8.0 basis points for the nine months ended September 30, 2008 and 2007, respectively. We previously calculated our credit loss ratio based on credit losses as a percentage of our mortgage credit book of business, which includes non-Fannie Mae mortgage-related securities held in our mortgage investment portfolio that we do not guarantee. Because losses related to non-Fannie Mae mortgage-related securities are not reflected in our credit losses, we revised the calculation of our credit loss ratio to reflect credit losses as a percentage of our guaranty book of business. Our credit loss ratio calculated based on our mortgage credit book of business would have been 28.4 basis points and 5.0 basis points for the three months ended September 30, 2008 and 2007, respectively, and 19.1 basis points and 4.0 basis points for the nine months ended September 30, 2008 and 2007, respectively.


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(19) Annualized net income (loss) available to common stockholders divided by average total assets during the period, expressed as a percentage. This ratio, which is considered a profitability measure, is a measure of how effectively we deploy our assets.
 
(20) Annualized net income (loss) available to common stockholders divided by average outstanding common equity during the period, expressed as a percentage. This ratio, which is considered a profitability measure, is a measure of our efficiency in generating profit from our equity.
 
(21) Average stockholders’ equity divided by average total assets during the period, expressed as a percentage. This ratio, which is considered a longer term solvency measure, is a measure of the extent to which we are using long-term funding to finance our assets.


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DESCRIPTION OF OUR BUSINESS
 
Our Role in the Secondary Mortgage Market
 
Fannie Mae is a government-sponsored enterprise chartered by Congress to support liquidity and stability in the secondary mortgage market, where existing mortgage loans are purchased and sold. We do not make mortgage loans to borrowers or conduct any other operations in the primary mortgage market, which is where mortgage loans are originated.
 
The Federal National Mortgage Association Charter Act sets forth the activities that we are permitted to conduct and states that our purpose is to:
 
  •  provide stability in the secondary market for residential mortgages;
 
  •  respond appropriately to the private capital market;
 
  •  provide ongoing assistance to the secondary market for residential mortgages (including activities relating to mortgages on housing for low- and moderate-income families involving a reasonable economic return that may be less than the return earned on other activities) by increasing the liquidity of mortgage investments and improving the distribution of investment capital available for residential mortgage financing; and
 
  •  promote access to mortgage credit throughout the nation (including central cities, rural areas and underserved areas) by increasing the liquidity of mortgage investments and improving the distribution of investment capital available for residential mortgage financing.
 
We securitize mortgage loans originated by lenders in the primary mortgage market into Fannie Mae MBS, which can then be readily bought and sold in the secondary mortgage market. We describe the securitization process below under “Business Segments—Single-Family Credit Guaranty Business—Mortgage Securitizations.” We also participate in the secondary mortgage market by purchasing mortgage loans and mortgage-related securities, including our own Fannie Mae MBS, for our mortgage portfolio. By selling loans and mortgage-related securities to us, lenders replenish their funds and, consequently, are able to make additional loans.
 
Although we are a corporation chartered by the U.S. Congress, the U.S. government does not guarantee, directly or indirectly, our securities or other obligations. It should be noted that, as described in “Executive Summary” above, pursuant to the Housing and Economic Recovery Act of 2008, Congress authorized Treasury to purchase our debt, equity and other securities, which authority Treasury used to make its commitment under the senior preferred stock purchase agreement to provide up to $100 billion in funds as needed to help us maintain a positive net worth (which means that our total assets exceed our total liabilities, as reflected on our GAAP balance sheet). In addition, we may request loans from Treasury under the Treasury credit facility.
 
Our Customers
 
Our principal customers are lenders that operate within the primary mortgage market, where mortgage loans are originated and funds are loaned to borrowers. Our customers also include mortgage banking companies, savings and loan associations, savings banks, commercial banks, credit unions, community banks, insurance companies, and state and local housing finance agencies.
 
Lenders originating mortgages in the primary mortgage market often sell them in the secondary mortgage market in the form of whole loans or in the form of mortgage-related securities.
 
During the third quarter of 2008, our top five lender customers, in the aggregate, accounted for approximately 60% of our single-family business volume, compared with 56% for the third quarter of 2007. Three lender customers each accounted for 10% or more of our single-family business volume for the third quarter of 2008: Bank of America Corporation and its affiliates, JPMorgan Chase and its affiliates and Wells Fargo & Company and its affiliates.


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Our top lender customer is Bank of America Corporation, which acquired Countrywide Financial Corporation on July 1, 2008. Because the transaction has only recently been completed, it is uncertain how the transaction will affect our future business volume. Our single-family business volume from the two companies has decreased compared to the third quarter of last year. Bank of America Corporation and its affiliates, following the acquisition of Countrywide Financial Corporation, accounted for approximately 20% of our single-family business volume for the third quarter of 2008. For the third quarter of 2007, Countrywide Financial Corporation and its affiliates accounted for approximately 25% of our single-family business volume and Bank of America Corporation accounted for approximately 5% of our single-family business volume.
 
Due to increasing consolidation within the mortgage industry, as well as a number of mortgage lenders having gone out of business since late 2006, we, as well as our competitors, seek business from a decreasing number of large mortgage lenders. As we become more reliant on a smaller number of lender customers, our negotiating leverage with these customers decreases, which could diminish our ability to price our products and services profitably. We discuss these and other risks that this customer concentration poses to our business in “Part II—Item 1A—Risk Factors.”
 
Business Segments
 
We are organized in three complementary business segments: Single-Family Credit Guaranty, Housing and Community Development, and Capital Markets.
 
Single-Family Credit Guaranty Business
 
Our Single-Family Credit Guaranty business (which we also refer to as our Single-Family business), works with our lender customers to securitize single-family mortgage loans into Fannie Mae MBS and to facilitate the purchase of single-family mortgage loans for our mortgage portfolio. Single-family mortgage loans relate to properties with four or fewer residential units. Revenues in the segment are derived primarily from guaranty fees received as compensation for assuming the credit risk on the mortgage loans underlying single-family Fannie Mae MBS and on the single-family mortgage loans held in our portfolio.
 
Mortgage Securitizations
 
Our most common type of securitization transaction is referred to as a “lender swap transaction.” Mortgage lenders that operate in the primary mortgage market generally deliver pools of mortgage loans to us in exchange for Fannie Mae MBS backed by these loans. After receiving the loans in a lender swap transaction, we place them in a trust that is established for the sole purpose of holding the loans separate and apart from our assets. We serve as trustee for the trust. Upon creation of the trust, we deliver to the lender (or its designee) Fannie Mae MBS that are backed by the pool of mortgage loans in the trust and that represent a beneficial ownership interest in each of the loans. We guarantee to each MBS trust that we will supplement amounts received by the MBS trust as required to permit timely payment of principal and interest on the related Fannie Mae MBS. We retain a portion of the interest payment as the fee for providing our guaranty. Then, on behalf of the trust, we make monthly distributions to the Fannie Mae MBS certificateholders from the principal and interest payments and other collections on the underlying mortgage loans.


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The following diagram illustrates the basic process by which we create a typical Fannie Mae MBS in the case where a lender chooses to sell the Fannie Mae MBS to a third-party investor.
 
(FLOW CHART)
 
We issue both single-class and multi-class Fannie Mae MBS. Single-class Fannie Mae MBS refers to Fannie Mae MBS where the investors receive principal and interest payments in proportion to their percentage ownership of the MBS issue. Multi-class Fannie Mae MBS refers to Fannie Mae MBS, including real estate mortgage investment conduits, or REMICs, where the cash flows on the underlying mortgage assets are divided, creating several classes of securities, each of which represents a beneficial ownership interest in a separate portion of cash flows. By separating the cash flows, the resulting classes may consist of: (1) interest-only payments; (2) principal-only payments; (3) different portions of the principal and interest payments; or (4) combinations of each of these. Terms to maturity of some multi-class Fannie Mae MBS, particularly REMIC classes, may match or be shorter than the maturity of the underlying mortgage loans and/or mortgage-related securities. As a result, each of the classes in a multi-class Fannie Mae MBS may have a different interest rate, average life, repayment sensitivity or final maturity. We also issue structured Fannie Mae MBS, which are either multi-class Fannie Mae MBS or resecuritized single-class Fannie Mae MBS.
 
MBS Trusts
 
Each of our single-family MBS trusts formed on or after June 1, 2007 is governed by the terms of our single-family master trust agreement. Each of our single-family MBS trusts formed prior to June 1, 2007 is governed either by our fixed-rate or adjustable-rate trust indenture. In addition, each MBS trust, regardless of the date of its formation, is governed by an issue supplement documenting the formation of that MBS trust and the issuance of the Fannie Mae MBS by that trust. The master trust agreement or the trust indenture, together with the issue supplement and any amendments, are the “trust documents” that govern an individual MBS trust. In accordance with the terms of our single-family MBS trust documents, we have the option or, in some instances, the obligation to purchase specified mortgage loans from an MBS trust. Refer to “Part I—Item 1—Business—Business Segments—Single-Family Credit Guaranty Business—MBS Trusts” of our 2007 Form 10-K for a description of the circumstances under which we have the option or the obligation to purchase loans from single-family MBS trusts. We amend our single-family trust documents from time to time. As a result, the circumstances under which we have the option or are required to purchase loans from single-family MBS trusts may change.


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Mortgage Acquisitions
 
We acquire single-family mortgage loans for securitization or for our investment portfolio through either our flow or bulk transaction channels. In our flow business, we enter into agreements that generally set agreed-upon guaranty fee prices for a lender’s future delivery of individual loans to us over a specified time period. Because these agreements can establish base guaranty fee prices for a specified period of time, we may be limited in our ability to renegotiate the pricing on our flow transactions with individual lenders to reflect changes in market conditions and the credit risk of mortgage loans that meet our eligibility standards. These agreements permit us, however, to charge risk-based price adjustments that can be altered depending on market conditions and that apply to all loans delivered to us with certain risk characteristics. Flow business represents the majority of our mortgage acquisition volumes.
 
Our bulk business generally consists of transactions in which a defined set of loans are to be delivered to us in bulk, and we have the opportunity to review the loans for eligibility and pricing prior to delivery in accordance with the terms of the applicable contracts. Guaranty fees and other contract terms for our bulk mortgage acquisitions are typically negotiated on an individual transaction basis. As a result, we generally have a greater ability to adjust our pricing more rapidly than in our flow transaction channel to reflect changes in market conditions and the credit risk of the specific transactions.
 
Mortgage Servicing
 
The servicing of the mortgage loans that are held in our mortgage portfolio or that back our Fannie Mae MBS is performed by mortgage servicers on behalf of Fannie Mae. Typically, lenders who sell single-family mortgage loans to us initially service the mortgage loans they sell to us. There is an active market in which single-family lenders sell servicing rights and obligations to other servicers. Our agreement with lenders requires our approval for all servicing transfers. If a mortgage servicer defaults, we have ultimate responsibility for servicing the loans we purchase or guarantee until a new servicer can be put in place. At times, we may engage a servicing entity to service loans on our behalf due to termination of a servicer’s servicing relationship or for other reasons. Since we delegate the servicing of our mortgage loans to mortgage servicers and do not have our own servicing function, it may limit our ability to actively manage troubled loans that we own or guarantee.
 
Mortgage servicers typically collect and deliver principal and interest payments, administer escrow accounts, monitor and report delinquencies, evaluate transfers of ownership interests, respond to requests for partial releases of security, and handle proceeds from casualty and condemnation losses. For problem loans, servicing includes negotiating workouts, engaging in loss mitigation and, if necessary, inspecting and preserving properties and processing foreclosures and bankruptcies. We have the right to remove servicing responsibilities from any servicer under criteria established in our contractual arrangements with servicers. We compensate servicers primarily by permitting them to retain a specified portion of each interest payment on a serviced mortgage loan, called a “servicing fee.” Servicers also generally retain prepayment premiums, assumption fees, late payment charges and other similar charges, to the extent they are collected from borrowers, as additional servicing compensation. We also compensate servicers for negotiating workouts on problem loans.
 
Refer to “Risk Management—Credit Risk Management—Institutional Counterparty Credit Risk Management” and “Part II—Item 1A—Risk Factors” for more information about our mortgage servicers and for discussions of the risks associated with a default by a mortgage servicer and how we seek to manage those risks.
 
Housing and Community Development Business
 
Our Housing and Community Development business (also referred to as our HCD business) works with our lender customers to securitize multifamily mortgage loans into Fannie Mae MBS and to facilitate the purchase of multifamily mortgage loans for our mortgage portfolio. Our HCD business also makes debt and equity investments to increase the supply of affordable housing. Revenues in the segment are derived from a variety of sources, including the guaranty fees received as compensation for assuming the credit risk on the mortgage loans underlying multifamily Fannie Mae MBS and on the multifamily mortgage loans held in our portfolio, transaction fees associated with the multifamily business and bond credit enhancement fees. In addition,


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HCD’s investments in rental housing projects eligible for the federal low-income housing tax credit and other investments generate both tax credits and net operating losses. As described in “Critical Accounting Policies and Estimates—Deferred Tax Assets,” we determined that it is more likely than not that we will not realize a portion of our deferred tax assets in the future. As a result, we are not currently recognizing tax benefits associated with these tax credits and net operating losses in our financial statements. Other investments in rental and for-sale housing generate revenue and losses from operations and the eventual sale of the assets.
 
Mortgage Securitizations
 
Our HCD business securitizes multifamily mortgage loans into Fannie Mae MBS. Multifamily mortgage loans relate to properties with five or more residential units, which may be apartment communities, cooperative properties or manufactured housing communities. Our HCD business generally creates multifamily Fannie Mae MBS in the same manner as our Single-Family business creates single-family Fannie Mae MBS. See “Single-Family Credit Guaranty Business—Mortgage Securitizations” for a description of a typical lender swap securitization transaction.
 
MBS Trusts
 
Each of our multifamily MBS trusts formed on or after September 1, 2007 is governed by the terms of our multifamily master trust agreement. Each of our multifamily MBS trusts formed prior to September 1, 2007 is governed either by our fixed-rate or adjustable-rate trust indenture. In addition, each MBS trust, regardless of the date of its formation, is governed by an issue supplement documenting the formation of that MBS trust and the issuance of the Fannie Mae MBS by that trust. In accordance with the terms of our multifamily MBS trust documents, we have the option or, in some instances, the obligation to purchase specified mortgage loans from an MBS trust. Refer to “Part I—Item 1—Business—Business Segments—Housing and Community Development Business—MBS Trusts” of our 2007 Form 10-K for a description of the circumstances under which we have the option or the obligation to purchase loans from multifamily MBS trusts. We amend our multifamily trust documents from time to time. As a result, the circumstances under which we have the option or are required to purchase loans from multifamily MBS trusts may change.
 
Mortgage Acquisitions
 
Our HCD business acquires multifamily mortgage loans for securitization or for our investment portfolio through either our flow or bulk transaction channels, in substantially the same manner as described under “Single-Family Credit Guaranty Business—Mortgage Acquisitions.” In recent years, the percentage of our multifamily business activity that has consisted of purchases for our investment portfolio has increased relative to our securitization activity.
 
Mortgage Servicing
 
As with the servicing of single-family mortgages, described under “Single-Family Credit Guaranty Business—Mortgage Servicing,” multifamily mortgage servicing is typically performed by the lenders who sell the mortgages to us. Many of those lenders have agreed, as part of the multifamily delegated underwriting and servicing relationship we have with these lenders, to accept “loss sharing” under certain defined circumstances with respect to mortgages that they have sold to us and are servicing. Thus, multifamily loss sharing obligations are an integral part of our selling and servicing relationships with multifamily lenders. Consequently, transfers of multifamily servicing rights are infrequent and are carefully monitored by us to enforce our right to approve all servicing transfers. As a seller-servicer, the lender is also responsible for evaluating the financial condition of owners, administering various types of agreements (including agreements regarding replacement reserves, completion or repair, and operations and maintenance), as well as conducting routine property inspections.


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Affordable Housing Investments
 
Our HCD business helps to expand the supply of affordable housing by investing in rental and for-sale housing projects. Most of these investments are in rental housing that is eligible for federal low-income housing tax credits, and the remainder are in conventional rental and primarily entry-level, for-sale housing. Refer to “Part I—Item 1—Business—Business Segments—Housing and Community Development Business—Affordable Housing Investments” of our 2007 Form 10-K for additional information relating to our affordable housing investments.
 
Capital Markets Group
 
Our Capital Markets group manages our investment activity in mortgage loans, mortgage-related securities and other investments, our debt financing activity, and our liquidity and capital positions. We fund our investments primarily through proceeds from our issuance of debt securities in the domestic and international capital markets.
 
Our Capital Markets group generates most of its revenue from the difference, or spread, between the interest we earn on our mortgage assets and the interest we pay on the debt we issue to fund these assets. We refer to this spread as our net interest yield. Changes in the fair value of the derivative instruments and trading securities we hold impact the net income or loss reported by the Capital Markets group business segment. The net income or loss reported by the Capital Markets group is also affected by the impairment of available-for-sale securities.
 
Mortgage Investments
 
Our mortgage investments include both mortgage-related securities and mortgage loans. We purchase primarily conventional (that is, loans that are not federally insured or guaranteed) single-family fixed-rate or adjustable-rate, first lien mortgage loans, or mortgage-related securities backed by these types of loans. In addition, we purchase loans insured by the Federal Housing Administration, loans guaranteed by the Department of Veterans Affairs or through the Rural Development Housing and Community Facilities Program of the Department of Agriculture, manufactured housing loans, multifamily mortgage loans, subordinate lien mortgage loans (for example, loans secured by second liens) and other mortgage-related securities. Most of these loans are prepayable at the option of the borrower. Our investments in mortgage-related securities include structured mortgage-related securities such as REMICs. For information on our mortgage investments, including the composition of our mortgage investment portfolio by product type, refer to “Consolidated Balance Sheet Analysis.”
 
Debt Financing Activities
 
Our Capital Markets group funds its investments primarily through the issuance of debt securities in the domestic and international capital markets. For information on our debt financing activities, refer to “Liquidity and Capital Management—Liquidity—Funding.”
 
Securitization Activities
 
Our Capital Markets group engages in two principal types of securitization activities:
 
  •  creating and issuing Fannie Mae MBS from our mortgage portfolio assets, either for sale into the secondary market or to retain in our portfolio; and
 
  •  issuing structured Fannie Mae MBS for customers in exchange for a transaction fee.
 
Our Capital Markets group creates Fannie Mae MBS using mortgage loans and mortgage-related securities that we hold in our investment portfolio, referred to as “portfolio securitizations.” We currently securitize a majority of the single-family mortgage loans we purchase within the first month of purchase. Our Capital Markets group may sell these Fannie Mae MBS into the secondary market or may retain the Fannie Mae MBS in our investment portfolio. In addition, the Capital Markets group issues structured Fannie Mae MBS, which


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are generally created through swap transactions, typically with our lender customers or securities dealer customers. In these transactions, the customer “swaps” a mortgage asset it owns for a structured Fannie Mae MBS we issue. Our Capital Markets group earns transaction fees for issuing structured Fannie Mae MBS for third parties.
 
Customer Services
 
Our Capital Markets group provides our lender customers and their affiliates with services that include offering to purchase a wide variety of mortgage assets, including non-standard mortgage loan products; segregating customer portfolios to obtain optimal pricing for their mortgage loans; and assisting customers with the hedging of their mortgage business. These activities provide a significant flow of assets for our mortgage portfolio, help to create a broader market for our customers and enhance liquidity in the secondary mortgage market.
 
CONSERVATORSHIP AND TREASURY AGREEMENTS
 
Conservatorship
 
On September 6, 2008, FHFA, our safety, soundness and mission regulator, was appointed as our conservator when the Director of FHFA placed us into conservatorship. The conservatorship is a statutory process designed to preserve and conserve our assets and property, and put the company in a sound and solvent condition. As conservator, FHFA has assumed the powers of our Board of Directors and management, as well as the powers of our stockholders. The powers of the conservator under the Regulatory Reform Act are summarized below.
 
The conservatorship has no specified termination date. In a Fact Sheet issued by FHFA on September 7, 2008, FHFA indicated that the Director of FHFA will issue an order terminating the conservatorship upon the Director’s determination that the conservator’s plan to restore the company to a safe and solvent condition has been completed successfully. FHFA’s September 7 Fact Sheet also indicated that, at present, there is no time frame that can be given as to when the conservatorship may end.
 
General Powers of the Conservator Under the Regulatory Reform Act
 
Upon its appointment, the conservator immediately succeeded to all rights, titles, powers and privileges of Fannie Mae, and of any stockholder, officer or director of Fannie Mae with respect to Fannie Mae and its assets, and succeeded to the title to all books, records and assets of Fannie Mae held by any other legal custodian or third party. The conservator has the power to take over our assets and operate our business with all the powers of our stockholders, directors and officers, and to conduct all business of the company.
 
The conservator may take any actions it determines are necessary and appropriate to carry on our business and preserve and conserve our assets and property. The conservator’s powers include the ability to transfer or sell any of our assets or liabilities (subject to limitations and post-transfer notice provisions for transfers of qualified financial contracts (as defined below under “Special Powers of the Conservator Under the Regulatory Reform Act—Security Interests Protected; Exercise of Rights Under Qualified Financial Contracts”)) without any approval, assignment of rights or consent. The Regulatory Reform Act, however, provides that mortgage loans and mortgage-related assets that have been transferred to a Fannie Mae MBS trust must be held for the beneficial owners of the Fannie Mae MBS and cannot be used to satisfy our general creditors.
 
In connection with any sale or disposition of our assets, the conservator must conduct its operations to maximize the net present value return from the sale or disposition, to minimize the amount of any loss realized, and to ensure adequate competition and fair and consistent treatment of offerors. The conservator is required to pay all of our valid obligations that were due and payable on September 6, 2008 (the date we were placed into conservatorship), but only to the extent that the proceeds realized from the performance of contracts or sale of our assets are sufficient to satisfy those obligations. In addition, the conservator is required to maintain a full accounting of the conservatorship and make its reports available upon request to stockholders and members of the public.


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We remain liable for all of our obligations relating to our outstanding debt securities and Fannie Mae MBS. In a Fact Sheet dated September 7, 2008, FHFA indicated that our obligations will be paid in the normal course of business during the conservatorship.
 
Special Powers of the Conservator Under the Regulatory Reform Act
 
Disaffirmance and Repudiation of Contracts
 
The conservator may disaffirm or repudiate contracts (subject to certain limitations for qualified financial contracts) that we entered into prior to its appointment as conservator if it determines, in its sole discretion, that performance of the contract is burdensome and that disaffirmation or repudiation of the contract promotes the orderly administration of our affairs. The Regulatory Reform Act requires FHFA to exercise its right to disaffirm or repudiate most contracts within a reasonable period of time after its appointment as conservator. As of November 7, 2008, the conservator had not determined whether or not a reasonable period of time had passed for purposes of the applicable provisions of the Regulatory Reform Act and, therefore, the conservator may still possess this right. As of November 7, 2008, the conservator has advised us that it has not disaffirmed or repudiated any contracts we entered into prior to its appointment as conservator.
 
We can, and have continued to, enter into and enforce contracts with third parties. The conservator has advised us that it has no intention of repudiating any guaranty obligation relating to Fannie Mae MBS because it views repudiation as incompatible with the goals of the conservatorship. In addition, as noted above, the conservator cannot use mortgage loans or mortgage-related assets that have been transferred to a Fannie Mae MBS trust to satisfy the general creditors of the company. The conservator must hold these assets for the beneficial owners of the related Fannie Mae MBS.
 
In general, the liability of the conservator for the disaffirmance or repudiation of any contract is limited to actual direct compensatory damages determined as of September 6, 2008, which is the date we were placed into conservatorship. The liability of the conservator for the disaffirmance or repudiation of a qualified financial contract is limited to actual direct compensatory damages determined as of the date of the disaffirmance or repudiation. If the conservator disaffirms or repudiates any lease to or from us, or any contract for the sale of real property, the Regulatory Reform Act specifies the liability of the conservator.
 
Limitations on Enforcement of Contractual Rights by Counterparties
 
The Regulatory Reform Act provides that the conservator may enforce most contracts entered into by us, notwithstanding any provision of the contract that provides for termination, default, acceleration, or exercise of rights upon the appointment of, or the exercise of rights or powers by, a conservator.
 
Security Interests Protected; Exercise of Rights Under Qualified Financial Contracts
 
Notwithstanding the conservator’s powers described above, the conservator must recognize legally enforceable or perfected security interests, except where such an interest is taken in contemplation of our insolvency or with the intent to hinder, delay or defraud us or our creditors. In addition, the Regulatory Reform Act provides that no person will be stayed or prohibited from exercising specified rights in connection with qualified financial contracts, including termination or acceleration (other than solely by reason of, or incidental to, the appointment of the conservator), rights of offset, and rights under any security agreement or arrangement or other credit enhancement relating to such contract. The term “qualified financial contract” means any securities contract, commodity contract, forward contract, repurchase agreement, swap agreement and any similar agreement, as determined by FHFA.
 
Avoidance of Fraudulent Transfers
 
The conservator may avoid, or refuse to recognize, a transfer of any property interest of Fannie Mae or of any of our debtors, and also may avoid any obligation incurred by Fannie Mae or by any debtor of Fannie Mae, if the transfer or obligation was made (1) within five years of September 6, 2008, and (2) with the intent to hinder, delay, or defraud Fannie Mae, FHFA, the conservator or, in the case of a transfer in connection with a


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qualified financial contract, our creditors. To the extent a transfer is avoided, the conservator may recover, for our benefit, the property or, by court order, the value of that property from the initial or subsequent transferee, unless the transfer was made for value and in good faith. These rights are superior to any rights of a trust or any other party, other than a federal agency, under the U.S. bankruptcy code.
 
Modification of Statutes of Limitations
 
Under the Regulatory Reform Act, notwithstanding any provision of any contract, the statute of limitations with regard to any action brought by the conservator is (1) for claims relating to a contract, the longer of six years or the applicable period under state law, and (2) for tort claims, the longer of three years or the applicable period under state law, in each case, from the later of September 6, 2008 or the date on which the cause of action accrues. In addition, notwithstanding the state law statute of limitation for tort claims, the conservator may bring an action for any tort claim that arises from fraud, intentional misconduct resulting in unjust enrichment, or intentional misconduct resulting in substantial loss to us, if the state’s statute of limitations expired not more than five years before September 6, 2008.
 
Suspension of Legal Actions
 
In any judicial action or proceeding to which we are or become a party, the conservator may request, and the applicable court must grant, a stay for a period not to exceed 45 days.
 
Treatment of Breach of Contract Claims
 
Any final and unappealable judgment for monetary damages against the conservator for breach of an agreement executed or approved in writing by the conservator will be paid as an administrative expense of the conservator.
 
Attachment of Assets and Other Injunctive Relief
 
The conservator may seek to attach assets or obtain other injunctive relief without being required to show that any injury, loss or damage is irreparable and immediate.
 
Subpoena Power
 
The Regulatory Reform Act provides the conservator, with the approval of the Director of FHFA, with subpoena power for purposes of carrying out any power, authority or duty with respect to Fannie Mae.
 
Current Management of the Company Under Conservatorship
 
As noted above, as our conservator, FHFA has assumed the powers of our Board of Directors. Accordingly, the current Board of Directors acts with neither the power nor the duty to manage, direct or oversee our business and affairs. The conservator has indicated that it intends to appoint a full Board of Directors to which it will delegate specified roles and responsibilities. Until FHFA has made these delegations, our Board of Directors has no power to determine the general policies that govern our operations, to create committees and elect the members of those committees, to select our officers, to manage, direct or oversee our business and affairs, or to exercise any of the other powers of the Board of Directors that are set forth in our Charter and bylaws.
 
FHFA, in its role as conservator, has overall management authority over our business. During the conservatorship, the conservator has delegated authority to management to conduct day-to-day operations so that the company can continue to operate in the ordinary course of business. The conservator retains the authority to withdraw its delegations to management at any time. The conservator is working actively with management to address and determine the strategic direction for the enterprise, and in general has retained final decision-making authority in areas regarding: significant impacts on operational, market, reputational or credit risk; major accounting determinations, including policy changes; the creation of subsidiaries or affiliates and transacting with them; significant litigation; setting executive compensation; retention of external auditors;


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significant mergers and acquisitions; and any other matters the conservator believes are strategic or critical to the enterprise in order for the conservator to fulfill its obligations during conservatorship.
 
Treasury Agreements
 
The Regulatory Reform Act granted Treasury temporary authority (through December 31, 2009) to purchase any obligations and other securities issued by Fannie Mae on such terms and conditions and in such amounts as Treasury may determine, upon mutual agreement between Treasury and Fannie Mae. As of November 7, 2008, Treasury had used this authority as follows.
 
Senior Preferred Stock Purchase Agreement and Related Issuance of Senior Preferred Stock and Common Stock Warrant
 
Senior Preferred Stock Purchase Agreement
 
On September 7, 2008, we, through FHFA, in its capacity as conservator, and Treasury entered into a senior preferred stock purchase agreement. The senior preferred stock purchase agreement was subsequently amended and restated on September 26, 2008. Pursuant to the agreement, we agreed to issue to Treasury one million shares of senior preferred stock with an initial liquidation preference equal to $1,000 per share (for an aggregate liquidation preference of $1.0 billion), and a warrant for the purchase of our common stock. The terms of the senior preferred stock and warrant are summarized in separate sections below. We did not receive any cash proceeds from Treasury as a result of issuing the senior preferred stock or the warrant.
 
The senior preferred stock and warrant were issued to Treasury as an initial commitment fee in consideration of the commitment from Treasury to provide up to $100 billion in funds to us under the terms and conditions set forth in the senior preferred stock purchase agreement. In addition to the issuance of the senior preferred stock and warrant, beginning on March 31, 2010, we are required to pay a quarterly commitment fee to Treasury. This quarterly commitment fee will accrue from January 1, 2010. The fee, in an amount to be mutually agreed upon by us and Treasury and to be determined with reference to the market value of Treasury’s funding commitment as then in effect, will be determined on or before December 31, 2009, and will be reset every five years. Treasury may waive the quarterly commitment fee for up to one year at a time, in its sole discretion, based on adverse conditions in the U.S. mortgage market. We may elect to pay the quarterly commitment fee in cash or add the amount of the fee to the liquidation preference of the senior preferred stock.
 
The senior preferred stock purchase agreement provides that, on a quarterly basis, we generally may draw funds up to the amount, if any, by which our total liabilities exceed our total assets, as reflected on our GAAP balance sheet for the applicable fiscal quarter (referred to as the “deficiency amount”), provided that the aggregate amount funded under the agreement may not exceed $100 billion. The senior preferred stock purchase agreement provides that the deficiency amount will be calculated differently if we become subject to receivership or other liquidation process. The deficiency amount may be increased above the otherwise applicable amount upon our mutual written agreement with Treasury. In addition, if the Director of FHFA determines that the Director will be mandated by law to appoint a receiver for us unless our capital is increased by receiving funds under the commitment in an amount up to the deficiency amount (subject to the $100 billion maximum amount that may be funded under the agreement), then FHFA, in its capacity as our conservator, may request that Treasury provide funds to us in such amount. The senior preferred stock purchase agreement also provides that, if we have a deficiency amount as of the date of completion of the liquidation of our assets, we may request funds from Treasury in an amount up to the deficiency amount (subject to the $100 billion maximum amount that may be funded under the agreement). Any amounts that we draw under the senior preferred stock purchase agreement will be added to the liquidation preference of the senior preferred stock. No additional shares of senior preferred stock are required to be issued under the senior preferred stock purchase agreement.
 
The senior preferred stock purchase agreement provides that the Treasury’s funding commitment will terminate under any the following circumstances: (1) the completion of our liquidation and fulfillment of Treasury’s obligations under its funding commitment at that time, (2) the payment in full of, or reasonable


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provision for, all of our liabilities (whether or not contingent, including mortgage guaranty obligations), or (3) the funding by Treasury of $100 billion under the agreement. In addition, Treasury may terminate its funding commitment and declare the senior preferred stock purchase agreement null and void if a court vacates, modifies, amends, conditions, enjoins, stays or otherwise affects the appointment of the conservator or otherwise curtails the conservator’s powers. Treasury may not terminate its funding commitment under the agreement solely by reason of our being in conservatorship, receivership or other insolvency proceeding, or due to our financial condition or any adverse change in our financial condition.
 
The senior preferred stock purchase agreement provides that most provisions of the agreement may be waived or amended by mutual written agreement of the parties; however, no waiver or amendment of the agreement is permitted that would decrease Treasury’s aggregate funding commitment or add conditions to Treasury’s funding commitment if the waiver or amendment would adversely affect in any material respect the holders of our debt securities or guaranteed Fannie Mae MBS.
 
In the event of our default on payments with respect to our debt securities or guaranteed Fannie Mae MBS, if Treasury fails to perform its obligations under its funding commitment and if we and/or the conservator are not diligently pursuing remedies in respect of that failure, the holders of our debt securities or Fannie Mae MBS may file a claim in the United States Court of Federal Claims for relief requiring Treasury to fund to us the lesser of (1) the amount necessary to cure the payment defaults on our debt and Fannie Mae MBS and (2) the lesser of (a) the deficiency amount and (b) $100 billion less the aggregate amount of funding previously provided under the commitment. Any payment that Treasury makes under those circumstances will be treated for all purposes as a draw under the senior preferred stock purchase agreement that will increase the liquidation preference of the senior preferred stock.
 
The senior preferred stock purchase agreement includes several covenants that significantly restrict our business activities, which are described below under “Covenants Under Treasury Agreements—Senior Preferred Stock Purchase Agreement Covenants.”
 
As of November 7, 2008, we have not drawn any amounts under the senior preferred stock purchase agreement. The amended and restated senior preferred stock purchase agreement is filed as an exhibit to this report.
 
Issuance of Senior Preferred Stock
 
Pursuant to the senior preferred stock purchase agreement described above, we issued one million shares of senior preferred stock to Treasury on September 8, 2008. The senior preferred stock was issued to Treasury in partial consideration of Treasury’s commitment to provide up to $100 billion in funds to us under the terms set forth in the senior preferred stock purchase agreement.
 
Shares of the senior preferred stock have no par value, and have a stated value and initial liquidation preference equal to $1,000 per share. The liquidation preference of the senior preferred stock is subject to adjustment. Dividends that are not paid in cash for any dividend period will accrue and be added to the liquidation preference of the senior preferred stock. In addition, any amounts Treasury pays to us pursuant to its funding commitment under the senior preferred stock purchase agreement and any quarterly commitment fees that are not paid in cash to Treasury or waived by Treasury will be added to the liquidation preference of the senior preferred stock. As described below, we may make payments to reduce the liquidation preference of the senior preferred stock.
 
Holders of the senior preferred stock are entitled to receive, when, as and if declared by our Board of Directors, cumulative quarterly cash dividends at the annual rate of 10% per year on the then-current liquidation preference of the senior preferred stock. The initial dividend, if declared, will be payable on December 31, 2008 and will be for the period from but not including September 8, 2008 through and including December 31, 2008. If at any time we fail to pay cash dividends in a timely manner, then immediately following such failure and for all dividend periods thereafter until the dividend period following the date on which we have paid in cash full cumulative dividends (including any unpaid dividends added to the liquidation preference), the dividend rate will be 12% per year.


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The senior preferred stock ranks ahead of our common stock and all other outstanding series of our preferred stock, as well as any capital stock we issue in the future, as to both dividends and rights upon liquidation. The senior preferred stock provides that we may not, at any time, declare or pay dividends on, make distributions with respect to, or redeem, purchase or acquire, or make a liquidation payment with respect to, any common stock or other securities ranking junior to the senior preferred stock unless (1) full cumulative dividends on the outstanding senior preferred stock (including any unpaid dividends added to the liquidation preference) have been declared and paid in cash, and (2) all amounts required to be paid with the net proceeds of any issuance of capital stock for cash (as described in the following paragraph) have been paid in cash. Shares of the senior preferred stock are not convertible. Shares of the senior preferred stock have no general or special voting rights, other than those set forth in the certificate of designation for the senior preferred stock or otherwise required by law. The consent of holders of at least two-thirds of all outstanding shares of senior preferred stock is generally required to amend the terms of the senior preferred stock or to create any class or series of stock that ranks prior to or on parity with the senior preferred stock.
 
We are not permitted to redeem the senior preferred stock prior to the termination of Treasury’s funding commitment set forth in the senior preferred stock purchase agreement; however, we are permitted to pay down the liquidation preference of the outstanding shares of senior preferred stock to the extent of (1) accrued and unpaid dividends previously added to the liquidation preference and not previously paid down; and (2) quarterly commitment fees previously added to the liquidation preference and not previously paid down. In addition, if we issue any shares of capital stock for cash while the senior preferred stock is outstanding, the net proceeds of the issuance must be used to pay down the liquidation preference of the senior preferred stock; however, the liquidation preference of each share of senior preferred stock may not be paid down below $1,000 per share prior to the termination of Treasury’s funding commitment. Following the termination of Treasury’s funding commitment, we may pay down the liquidation preference of all outstanding shares of senior preferred stock at any time, in whole or in part. If, after termination of Treasury’s funding commitment, we pay down the liquidation preference of each outstanding share of senior preferred stock in full, the shares will be deemed to have been redeemed as of the payment date.
 
The certificate of designation for the senior preferred stock is filed as an exhibit to this report.
 
Issuance of Common Stock Warrant
 
Pursuant to the senior preferred stock purchase agreement described above, on September 7, 2008, we, through FHFA, in its capacity as conservator, issued a warrant to purchase common stock to Treasury. The warrant was issued to Treasury in partial consideration of Treasury’s commitment to provide up to $100 billion in funds to us under the terms set forth in the senior preferred stock purchase agreement.
 
The warrant gives Treasury the right to purchase shares of our common stock equal to 79.9% of the total number of shares of our common stock outstanding on a fully diluted basis on the date of exercise. The warrant may be exercised in whole or in part at any time on or before September 7, 2028, by delivery to us of: (a) a notice of exercise; (b) payment of the exercise price of $0.00001 per share; and (c) the warrant. If the market price of one share of our common stock is greater than the exercise price, then, instead of paying the exercise price, Treasury may elect to receive shares equal to the value of the warrant (or portion thereof being canceled) pursuant to the formula specified in the warrant. Upon exercise of the warrant, Treasury may assign the right to receive the shares of common stock issuable upon exercise to any other person. The warrant contains several covenants, which are described under “Covenants Under Treasury Agreements—Warrant Covenants.”
 
As of November 7, 2008, Treasury has not exercised the warrant. The warrant is filed as an exhibit to this report.
 
Treasury Credit Facility
 
On September 19, 2008, we entered into a lending agreement with Treasury under which we may request loans until December 31, 2009. Loans under the Treasury credit facility require approval from Treasury at the time of request. Treasury is not obligated under the credit facility to make, increase, renew or extend any loan


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to us. The credit facility does not specify a maximum amount that may be borrowed under the credit facility, but any loans made to us by Treasury pursuant to the credit facility must be collateralized by Fannie Mae MBS or Freddie Mac mortgage-backed securities. Refer to “Liquidity and Capital Management—Liquidity—Liquidity Risk Management—Liquidity Contingency Plan—Treasury Credit Facility” for a discussion of the collateral that we could pledge under the Treasury credit facility. Further, unless amended or waived by Treasury, the amount we may borrow under the credit facility is limited by the restriction under the senior preferred stock purchase agreement on incurring debt in excess of 110% of our aggregate indebtedness as of June 30, 2008.
 
The credit facility does not specify the maturities or interest rate of loans that may be made by Treasury under the credit facility. In a Fact Sheet regarding the credit facility published by Treasury on September 7, 2008, Treasury indicated that loans made pursuant to the credit facility will be for short-term durations and would in general be expected to be for less than one month but no shorter than one week. The Fact Sheet further indicated that the interest rate on loans made pursuant to the credit facility ordinarily will be based on the daily London Inter-bank Offer Rate, or LIBOR, for a similar term of the loan plus 50 basis points. Given that the interest rate we are likely to be charged under the credit facility will be significantly higher than the rates we have historically achieved through the sale of unsecured debt, use of the facility, particularly in significant amounts, is likely to have a material adverse impact on our financial results.
 
As of November 7, 2008, we have not requested any loans or borrowed any amounts under the Treasury credit facility. For a description of the covenants contained in the credit facility, refer to “Covenants under Treasury Agreements—Treasury Credit Facility Covenants” below. A copy of the lending agreement for the Treasury credit facility is filed as an exhibit to this report.
 
Covenants under Treasury Agreements
 
The senior preferred stock purchase agreement, warrant and Treasury credit facility contain covenants that significantly restrict our business activities. These covenants, which are summarized below, include a prohibition on our issuance of additional equity securities (except in limited instances), a prohibition on the payment of dividends or other distributions on our equity securities (other than the senior preferred stock or warrant), a prohibition on our issuance of subordinated debt and a limitation on the total amount of debt securities we may issue. As a result, we can no longer obtain additional equity financing (other than pursuant to the senior preferred stock purchase agreement) and we are limited in the amount and type of debt financing we may obtain.
 
Senior Preferred Stock Purchase Agreement Covenants
 
The senior preferred stock purchase agreement provides that, until the senior preferred stock is repaid or redeemed in full, we may not, without the prior written consent of Treasury:
 
  •  Declare or pay any dividend (preferred or otherwise) or make any other distribution with respect to any Fannie Mae equity securities (other than with respect to the senior preferred stock or warrant);
 
  •  Redeem, purchase, retire or otherwise acquire any Fannie Mae equity securities (other than the senior preferred stock or warrant);
 
  •  Sell or issue any Fannie Mae equity securities (other than the senior preferred stock, the warrant and the common stock issuable upon exercise of the warrant and other than as required by the terms of any binding agreement in effect on the date of the senior preferred stock purchase agreement);
 
  •  Terminate the conservatorship (other than in connection with a receivership);
 
  •  Sell, transfer, lease or otherwise dispose of any assets, other than dispositions for fair market value: (a) to a limited life regulated entity (in the context of a receivership); (b) of assets and properties in the ordinary course of business, consistent with past practice; (c) in connection with our liquidation by a receiver; (d) of cash or cash equivalents for cash or cash equivalents; or (e) to the extent necessary to comply with the covenant described below relating to the reduction of our mortgage assets beginning in 2010;


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  •  Incur indebtedness that would result in our aggregate indebtedness exceeding 110% of our aggregate indebtedness as of June 30, 2008;
 
  •  Issue any subordinated debt;
 
  •  Enter into a corporate reorganization, recapitalization, merger, acquisition or similar event; or
 
  •  Engage in transactions with affiliates unless the transaction is (a) pursuant to the senior preferred stock purchase agreement, the senior preferred stock or the warrant, (b) upon arm’s length terms or (c) a transaction undertaken in the ordinary course or pursuant to a contractual obligation or customary employment arrangement in existence on the date of the senior preferred stock purchase agreement.
 
The senior preferred stock purchase agreement also provides that we may not own mortgage assets in excess of (a) $850 billion on December 31, 2009, or (b) on December 31 of each year thereafter, 90% of the aggregate amount of our mortgage assets as of December 31 of the immediately preceding calendar year, provided that we are not required to own less than $250 billion in mortgage assets. The covenant in the agreement prohibiting us from issuing debt in excess of 110% of our aggregate indebtedness as of June 30, 2008 likely will prohibit us from increasing the size of our mortgage portfolio to $850 billion, unless Treasury elects to amend or waive this limitation.
 
In addition, the senior preferred stock purchase agreement provides that we may not enter into any new compensation arrangements or increase amounts or benefits payable under existing compensation arrangements of any named executive officer (as defined by SEC rules) without the consent of the Director of FHFA, in consultation with the Secretary of the Treasury.
 
We are required under the senior preferred stock purchase agreement to provide annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K to Treasury in accordance with the time periods specified in the SEC’s rules. In addition, our designated representative (which, during the conservatorship, is the conservator) is required to provide quarterly certifications to Treasury certifying compliance with the covenants contained in the senior preferred stock purchase agreement and the accuracy of the representations made pursuant to agreement. We also are obligated to provide prompt notice to Treasury of the occurrence of specified events, such as the filing of a lawsuit that would reasonably be expected to have a material adverse effect.
 
As of November 7, 2008, we believe we were in compliance with the material covenants under the senior preferred stock purchase agreement. For a summary of the terms of the senior preferred stock purchase agreement, see “Senior Preferred Stock Purchase Agreement and Related Issuance of Senior Preferred Stock and Common Stock Warrant—Senior Preferred Stock Purchase Agreement” above. For the complete terms of the covenants, see the senior preferred stock purchase agreement filed as an exhibit to this report.
 
Warrant Covenants
 
The warrant we issued to Treasury includes, among others, the following covenants:
 
  •  Our SEC filings under the Exchange Act will comply in all material respects as to form with the Exchange Act and the rules and regulations thereunder;
 
  •  We may not permit any of our significant subsidiaries to issue capital stock or equity securities, or securities convertible into or exchangeable for such securities, or any stock appreciation rights or other profit participation rights;
 
  •  We may not take any action that will result in an increase in the par value of our common stock;
 
  •  We may not take any action to avoid the observance or performance of the terms of the warrant and we must take all actions necessary or appropriate to protect Treasury’s rights against impairment or dilution; and
 
  •  We must provide Treasury with prior notice of specified actions relating to our common stock, including setting a record date for a dividend payment, granting subscription or purchase rights, authorizing a


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  recapitalization, reclassification, merger or similar transaction, commencing a liquidation of the company or any other action that would trigger an adjustment in the exercise price or number or amount of shares subject to the warrant.
 
The warrant remains outstanding through September 7, 2028.
 
As of November 7, 2008, we believe we were in compliance with the material covenants under the warrant. For a summary of the terms of the warrant, see “Senior Preferred Stock Purchase Agreement and Related Issuance of Senior Preferred Stock and Common Stock Warrant—Issuance of Common Stock Warrant” above. For the complete terms of the covenants contained in the warrant, a copy of the warrant is filed as an exhibit to this report.
 
Treasury Credit Facility Covenants
 
The Treasury credit facility includes covenants requiring us, among other things:
 
  •  to maintain Treasury’s security interest in the collateral, including the priority of the security interest, and take actions to defend against adverse claims;
 
  •  not to sell or otherwise dispose of, pledge or mortgage the collateral (other than Treasury’s security interest);
 
  •  not to act in any way to impair, or to fail to act in a way to prevent the impairment of, Treasury’s rights or interests in the collateral;
 
  •  promptly to notify Treasury of any failure or impending failure to meet our regulatory capital requirements;
 
  •  to provide for periodic audits of collateral held under borrower-in-custody arrangements, and to comply with certain notice and certification requirements;
 
  •  promptly to notify Treasury of the occurrence or impending occurrence of an event of default under the terms of the lending agreement; and
 
  •  to notify Treasury of any change in applicable law or regulations, or in our charter or bylaws, or certain other events, that may materially affect our ability to perform our obligations under the lending agreement.
 
The Treasury credit facility expires on December 31, 2009.
 
As of November 7, 2008, we believe we were in compliance with the material covenants under the Treasury credit facility. For a summary of the terms of the Treasury credit facility, see “Treasury Credit Facility” above. For the complete terms of the covenants contained in the Treasury credit facility, a copy of the agreement is filed as an exhibit to this report.
 
Effect of Conservatorship and Treasury Agreements on Stockholders
 
The conservatorship and senior preferred stock purchase agreement have materially limited the rights of our common and preferred stockholders (other than Treasury as holder of the senior preferred stock). The conservatorship has had the following adverse effects on our common and preferred stockholders:
 
  •  the powers of the stockholders are suspended during the conservatorship. Accordingly, our common stockholders do not have the ability to elect directors or to vote on other matters during the conservatorship unless the conservator delegates this authority to them;
 
  •  the conservator has eliminated common and preferred stock dividends (other than dividends on the senior preferred stock) during the conservatorship; and
 
  •  according to a statement made by the Treasury Secretary on September 7, 2008, because we are in conservatorship, we “will no longer be managed with a strategy to maximize common shareholder returns.”


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The senior preferred stock purchase agreement and the senior preferred stock and warrant issued to Treasury pursuant to the agreement have had the following adverse effects on our common and preferred stockholders:
 
  •  the senior preferred stock ranks senior to the common stock and all other series of preferred stock as to both dividends and distributions upon dissolution, liquidation or winding up of the company;
 
  •  the senior preferred stock purchase agreement prohibits the payment of dividends on common or preferred stock (other than the senior preferred stock) without the prior written consent of Treasury; and
 
  •  the warrant provides Treasury with the right to purchase shares of our common stock equal to up to 79.9% of the total number of shares of our common stock outstanding on a fully diluted basis on the date of exercise for a nominal price, thereby substantially diluting the ownership in Fannie Mae of our common stockholders at the time of exercise. Until Treasury exercises its rights under the warrant or its right to exercise the warrant expires on September 7, 2028 without having been exercised, the holders of our common stock continue to have the risk that, as a group, they will own no more than 20.1% of the total voting power of the company. Under our Charter, bylaws and applicable law, 20.1% is insufficient to control the outcome of any vote that is presented to the common shareholders. Accordingly, existing common shareholders have no assurance that, as a group, they will be able to control the election of our directors or the outcome of any other vote after the time, if any, that the conservatorship ends.
 
As described above, the conservatorship and Treasury agreements also impact our business in ways that indirectly affect our common and preferred stockholders. By their terms, the senior preferred stock purchase agreement, senior preferred stock and warrant will continue to exist even if we are released from the conservatorship. For a description of the risks to our business relating to the conservatorship and Treasury agreements, see “Part II—Item 1A—Risk Factors.”
 
New York Stock Exchange Matters
 
As of November 7, 2008, our common stock continues to trade on the New York Stock Exchange, or NYSE. We have been in discussions with the staff of the NYSE regarding the effect of the conservatorship on our ongoing compliance with the rules of the NYSE and the continued listing of our stock on the NYSE in light of the unique circumstances of the conservatorship. To date, we have not been informed of any non-compliance by the NYSE.
 
Other Regulatory Matters
 
FHFA is responsible for implementing the various provisions of the Regulatory Reform Act. In a statement published on September 7, 2008, the Director of FHFA indicated that FHFA will continue to work expeditiously on the many regulations needed to implement the new legislation, and that some of the key regulations will address minimum capital standards, prudential safety and soundness standards and portfolio limits. In general, we remain subject to existing regulations, orders and determinations until new ones are issued or made.
 
Since we entered into conservatorship on September 6, 2008, FHFA has taken the following actions relating to the implementation of provisions of the Regulatory Reform Act.
 
Adoption by FHFA of Regulation Relating to Golden Parachute Payments
 
FHFA issued interim final regulations pursuant to the Regulatory Reform Act relating to “golden parachute payments” in September 2008. Under these regulations, FHFA may limit golden parachute payments as defined. In September 2008, the Director of FHFA notified us that severance and other payments contemplated in the employment contract of Daniel H. Mudd, our former President and Chief Executive Officer, are golden parachute payments within the meaning of the Regulatory Reform Act and that these payments should not be paid, effective immediately.


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Suspension of Regulatory Capital Requirements During Conservatorship
 
As described in “Liquidity and Capital Management—Capital Management—Regulatory Capital Requirements,” FHFA announced in October 2008 that our existing statutory and FHFA-directed regulatory capital requirements will not be binding during the conservatorship.
 
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
 
The preparation of financial statements in accordance with generally accepted accounting principles, or GAAP, requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in the consolidated financial statements. Understanding our accounting policies and the extent to which we use management judgment and estimates in applying these policies is integral to understanding our financial statements. We have identified the following as our most critical accounting policies and estimates:
 
  •  Fair Value of Financial Instruments
 
  •  Other-than-temporary Impairment of Investment Securities
 
  •  Allowance for Loan Losses and Reserve for Guaranty Losses
 
  •  Deferred Tax Assets
 
We describe below significant changes in the judgments and assumptions we made during the first nine months of 2008 in applying our critical accounting policies and estimates. Also see “Part II—Item 7—MD&A—Critical Accounting Policies and Estimates” of our 2007 Form 10-K for additional information about our critical accounting policies and estimates. We rely on a number of valuation and risk models as the basis for some of the amounts recorded in our financial statements. Many of these models involve significant assumptions and have certain limitations. See “Part II—Item 1A—Risk Factors” for a discussion of the risks associated with the use of models.
 
Fair Value of Financial Instruments
 
The use of fair value to measure our financial instruments is fundamental to our financial statements and is a critical accounting estimate because we account for and record a substantial portion of our assets and liabilities at fair value. As we discuss more fully in “Notes to Condensed Consolidated Financial Statements—Note 18, Fair Value of Financial Instruments,” we adopted SFAS No. 157, Fair Value Measurements (“SFAS 157”) effective January 1, 2008. SFAS 157 defines fair value, establishes a framework for measuring fair value and outlines a fair value hierarchy based on the inputs to valuation techniques used to measure fair value. Fair value represents the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (also referred to as an exit price). In determining fair value, we use various valuation techniques. We disclose the carrying value and fair value of our financial assets and liabilities and describe the specific valuation techniques used to determine the fair value of these financial instruments in Note 18 to the condensed consolidated financial statements.
 
In September 2008, the SEC and FASB issued joint guidance providing clarification of issues surrounding the determination of fair value measurements under the provisions of SFAS 157 in the current market environment. In October 2008, the FASB issued FASB Staff Position No. FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active, which amended SFAS 157 to provide an illustrative example of how to determine the fair value of a financial asset when the market for that financial asset is not active. The SEC and FASB guidance did not have an impact on our application of SFAS 157.
 
We generally consider a market to be inactive if the following conditions exist: (1) there are few transactions for the financial instruments; (2) the prices in the market are not current; (3) the price quotes we receive vary significantly either over time or among independent pricing services or dealers; and (4) there is a limited availability of public market information.


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SFAS 157 establishes a three-level fair value hierarchy for classifying financial instruments that is based on whether the inputs to the valuation techniques used to measure fair value are observable or unobservable. The three levels of the SFAS 157 fair value hierarchy are described below:
 
Level 1:  Quoted prices (unadjusted) in active markets for identical assets or liabilities.
 
  Level 2:   Observable market-based inputs, other than quoted prices in active markets for identical assets or liabilities.
 
Level 3:  Unobservable inputs.
 
Each asset or liability is assigned to a level based on the lowest level of any input that is significant to the fair value measurement.
 
The majority of our financial instruments carried at fair value fall within the level 2 category and are valued primarily utilizing inputs and assumptions that are observable in the marketplace, that can be derived from observable market data or that can be corroborated by recent trading activity of similar instruments with similar characteristics. Because items classified as level 3 are valued using significant unobservable inputs, the process for determining the fair value of these items is generally more subjective and involves a high degree of management judgment and assumptions. These assumptions may have a significant effect on our estimates of fair value, and the use of different assumptions as well as changes in market conditions could have a material effect on our results of operations or financial condition.
 
Fair Value Hierarchy—Level 3 Assets and Liabilities
 
Our level 3 assets and liabilities consist primarily of financial instruments for which the fair value is estimated using valuation techniques that involve significant unobservable inputs because there is limited market activity and therefore little or no price transparency. We typically classify financial instruments as level 3 if the valuation is based on inputs from a single source, such as a dealer quotation, and we are not able to corroborate the inputs and assumptions with other available, observable market information. Our level 3 financial instruments include certain mortgage- and asset-backed securities and residual interests, certain performing residential mortgage loans, non-performing mortgage-related assets, our guaranty assets and buy-ups, our master servicing assets and certain highly structured, complex derivative instruments. As described in “Consolidated Results of Operations—Guaranty Fee Income,” we use the term “buy-ups” to refer to upfront payments that we make to lenders to adjust the monthly contractual guaranty fee rate so that the pass-through coupon rates on Fannie Mae MBS are in more easily tradable increments of a whole or half percent.
 
The following discussion identifies the types of financial assets we hold within each balance sheet category that are based on level 3 inputs and the valuation techniques we use to determine their fair values, including key inputs and assumptions.
 
  •  Trading and Available-for-Sale Investment Securities.  Our financial instruments within these asset categories that are classified as level 3 primarily consist of mortgage-related securities backed by Alt-A and subprime loans and mortgage revenue bonds. We generally have estimated the fair value of these securities at an individual security level, using non-binding prices obtained from at least four independent pricing services. Our fair value estimate is based on the average of these prices, which we regard as level 2. In the absence of such information or if we are not able to corroborate these prices by other available, relevant market information, we estimate their fair values based on single source quotations from brokers or dealers or by using internal calculations or discounted cash flow techniques that incorporate inputs, such as prepayment rates, discount rates and delinquency, default and cumulative loss expectations, that are implied by market prices for similar securities and collateral structure types. Because this valuation technique involves some level 3 inputs, we classify securities that are valued in this manner as level 3.
 
  •  Derivatives.  Our derivative financial instruments that are classified as level 3 primarily consist of a limited population of certain highly structured, complex interest rate risk management derivatives.


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  Examples include certain swaps with embedded caps and floors that reference non-standard indices. We determine the fair value of these derivative instruments using indicative market prices obtained from independent third parties. If we obtain a price from a single source and we are not able to corroborate that price, the fair value measurement is classified as level 3.
 
  •  Guaranty Assets and Buy-ups.  We determine the fair value of our guaranty assets and buy-ups based on the present value of the estimated compensation we expect to receive for providing our guaranty. We generally estimate the fair value using proprietary internal models that calculate the present value of expected cash flows. Key model inputs and assumptions include prepayment speeds, forward yield curves and discount rates that are commensurate with the level of estimated risk.
 
Fair value measurements related to financial instruments that are reported at fair value in our consolidated financial statements each period, such as our trading and available-for-sale securities and derivatives, are referred to as recurring fair value measurements. Fair value measurements related to financial instruments that are not reported at fair value each period, such as held-for-sale mortgage loans, are referred to non-recurring fair value measurement.
 
Table 1 presents, by balance sheet category, the amount of financial assets carried in our condensed consolidated balance sheets at fair value on a recurring basis and classified as level 3 as of September 30, 2008 and June 30, 2008. The availability of observable market inputs to measure fair value varies based on changes in market conditions, such as liquidity. As a result, we expect the financial instruments carried at fair value on a recurring basis and classified as level 3 to vary each period.
 
Table 1:  Level 3 Recurring Financial Assets at Fair Value
 
                 
    As of  
    September 30,
    June 30,
 
Balance Sheet Category
  2008     2008  
    (Dollars in millions)  
 
Trading securities
  $ 14,173     $ 14,325  
Available-for-sale securities
    53,323       40,033  
Derivatives assets
    280       270  
Guaranty assets and buy-ups
    1,866       1,947  
                 
Level 3 recurring assets
  $ 69,642     $ 56,575  
                 
Total assets
  $ 896,615     $ 885,918  
Total recurring assets measured at fair value
  $ 363,689     $ 347,748  
Level 3 recurring assets as a percentage of total assets
    8 %     6 %
Level 3 recurring assets as a percentage of total recurring assets measured at fair value
    19 %     16 %
Total recurring assets measured at fair value as a percentage of total assets
    41 %     39 %
 
Level 3 recurring assets totaled $69.6 billion, or 8% of our total assets, as of September 30, 2008, compared with 6% of our total assets as of June 30, 2008. The balance of level 3 recurring assets increased by $13.1 billion and $28.4 billion during the third quarter of 2008 and first nine months of 2008, respectively. The increase in level 3 balances during the third quarter of 2008 resulted from the transfer of approximately $21.0 billion in assets to level 3 from level 2, which was partially offset by liquidations during the period. These assets primarily consisted of private-label mortgage-related securities backed by Alt-A loans or subprime loans. The transfers to level 3 from level 2 reflect the ongoing effects of the extreme disruption in the mortgage market and severe reduction in market liquidity for certain mortgage products, such as private-label mortgage-related securities backed by Alt-A loans or subprime loans. Because of the reduction in recently executed transactions and market price quotations for these instruments, the market inputs for these instruments are less observable.
 
Financial assets measured at fair value on a non-recurring basis and classified as level 3, which are not presented in the table above, include held-for-sale loans that are measured at lower of cost or market and that were written down to fair value during the period. Held-for-sale loans that were reported at fair value, rather than amortized cost, totaled $1.1 billion as of September 30, 2008. In addition, certain other financial assets carried at amortized cost that have been written down to fair value during the period due to impairment are


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classified as non-recurring. The fair value of these level 3 non-recurring financial assets, which primarily consisted of certain guaranty assets and acquired property, totaled $12.0 billion as of September 30, 2008. Financial liabilities measured at fair value on a recurring basis and classified as level 3 as of September 30, 2008 consisted of long-term debt with a fair value of $2.5 billion and derivatives liabilities with a fair value of $209 million.
 
Fair Value Control Processes
 
We have control processes that are designed to ensure that our fair value measurements are appropriate and reliable, that they are based on observable inputs wherever possible and that our valuation approaches are consistently applied and the assumptions used are reasonable. Our control processes consist of a framework that provides for a segregation of duties and oversight of our fair value methodologies and valuations and validation procedures.
 
Our Valuation Oversight Committee, which includes senior representation from business areas, our risk oversight office and finance, is responsible for reviewing and approving the valuation methodologies and pricing models used in our fair value measurements and any significant valuation adjustments, judgments, controls and results. Actual valuations are performed by personnel independent of our business units. Our Price Verification Group, which is an independent control group separate from the group that is responsible for obtaining the prices, also is responsible for performing monthly independent price verification. The Price Verification Group also performs independent reviews of the assumptions used in determining the fair value of products we hold that have material estimation risk because observable market-based inputs do not exist.
 
Our validation procedures are intended to ensure that the individual prices we receive are consistent with our observations of the marketplace and prices that are provided to us by pricing services or other dealers. We verify selected prices using a variety of methods, including comparing the prices to secondary pricing services, corroborating the prices by reference to other independent market data, such as non-binding broker or dealer quotations, relevant benchmark indices, and prices of similar instruments, checking prices for reasonableness based on variations from prices provided in previous periods, comparing prices to internally calculated expected prices and conducting relative value comparisons based on specific characteristics of securities. In addition, we compare our derivatives valuations to counterparty valuations as part of the collateral exchange process. We have formal discussions with the pricing services as part of our due diligence process in order to maintain a current understanding of the models and related assumptions and inputs that these vendors use in developing prices. The prices provided to us by independent pricing services reflect the existence of credit enhancements, including monoline insurance coverage, and the current lack of liquidity in the marketplace. If we determine that a price provided to us is outside established parameters, we will further examine the price, including having follow-up discussions with the specific pricing service or dealer. If we conclude that a price is not valid, we will adjust the price for various factors, such as liquidity, bid-ask spreads and credit considerations. These adjustments are generally based on available market evidence. In the absence of such evidence, management’s best estimate is used. All of these processes are executed before we use the prices in the financial statement process.
 
We continually refine our valuation methodologies as markets and products develop and the pricing for certain products becomes more or less transparent. While we believe our valuation methods are appropriate and consistent with those of other market participants, using different methodologies or assumptions to determine fair value could result in a materially different estimate of the fair value of some of our financial instruments.
 
Change in Measuring the Fair Value of Guaranty Obligations
 
Beginning January 1, 2008, as part of our implementation of SFAS 157, we changed our approach to measuring the fair value of our guaranty obligations. Specifically, we adopted a measurement approach that is based upon an estimate of the compensation that we would require to issue the same guaranty in a standalone arm’s-length transaction with an unrelated party. For a guaranty issued in a lender swap transaction after December 31, 2007, we measure the fair value of the guaranty obligation upon initial recognition based on the fair value of the total compensation we receive, which primarily consists of the guaranty fee, credit


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enhancements, buy-downs, risk-based price adjustments and our right to receive interest income during the float period in excess of the amount required to compensate us for master servicing. See “Consolidated Results of Operations—Guaranty Fee Income” for a description of buy-downs and risk-based price adjustments. As the fair value at inception of these guaranty obligations is now measured as equal to the fair value of the total compensation we expect to receive, we do not recognize losses or record deferred profit in our financial statements at the inception of guaranty contracts issued after December 31, 2007.
 
We also changed how we measure the fair value of our existing guaranty obligations, as discussed in “Supplemental Non-GAAP Information—Fair Value Balance Sheets” and in “Notes to Condensed Consolidated Financial Statements,” to be consistent with our approach for measuring guaranty obligations at initial recognition. The fair value of any guaranty obligation measured after its initial recognition represents our estimate of a hypothetical transaction price we would receive if we were to issue our guaranty to an unrelated party in a standalone arm’s-length transaction at the measurement date. To measure this fair value, we continue to use the models and inputs that we used prior to our adoption of SFAS 157 and calibrate those models to our current market pricing.
 
Prior to January 1, 2008, we measured the fair value of the guaranty obligations that we recorded when we issued Fannie Mae MBS based on market information obtained from spot transaction prices. In the absence of spot transaction data, which was the case for the substantial majority of our guarantees, we used internal models to estimate the fair value of our guaranty obligations. We reviewed the reasonableness of the results of our models by comparing those results with available market information. Key inputs and assumptions used in our models included the amount of compensation required to cover estimated default costs, including estimated unrecoverable principal and interest that we expected to incur over the life of the underlying mortgage loans backing our Fannie Mae MBS, estimated foreclosure-related costs, estimated administrative and other costs related to our guaranty, and an estimated market risk premium, or profit, that a market participant of similar credit standing would require to assume the obligation. If our modeled estimate of the fair value of the guaranty obligation was more or less than the fair value of the total compensation received, we recognized a loss or recorded deferred profit, respectively, at inception of the guaranty contract. See “Part II—Item 7—MD&A—Critical Accounting Policies and Estimates—Fair Value of Financial Instruments—Fair Value of Guaranty Assets and Guaranty Obligations—Effect on Losses on Certain Guaranty Contracts” of our 2007 Form 10-K for additional information.
 
The accounting for guarantees issued prior to January 1, 2008 is unchanged with our adoption of SFAS 157. Accordingly, the guaranty obligation amounts recorded in our condensed consolidated balance sheets attributable to these guarantees will continue to be amortized in accordance with our established accounting policy. This change, however, affects how we determine the fair value of our existing guaranty obligations as of each balance sheet date. See “Supplemental Non-GAAP Information—Fair Value Balance Sheets” and “Notes to Condensed Consolidated Financial Statements” for additional information regarding the impact of this change.
 
Other-than-temporary Impairment of Investment Securities
 
We determine whether our available-for-sale securities in an unrealized loss position are other-than-temporarily impaired as of the end of each quarter. We evaluate the probability that we will not collect all of the contractual amounts due and our ability and intent to hold the security until recovery in determining whether a security has suffered an other-than-temporary decline in value in accordance with the guidance provided in FASB Staff Position Nos. FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (“FSP 115-1 and FSP 124-1”). As more fully discussed in our 2007 Form 10-K in “Part II—Item 7—MD&A—Critical Accounting Policies and Estimates—Other-than-temporary Impairment of Investment Securities,” our evaluation requires management judgment and a consideration of various factors, including, but not limited to, the severity and duration of the impairment; recent events specific to the issuer and/or the industry to which the issuer belongs; and external credit ratings. Although an external rating agency action or a change in a security’s external credit rating is one criterion in our assessment of other-than-temporary impairment, a rating action alone is not necessarily indicative of other-than-temporary impairment.


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We employ models to assess the expected performance of our securities under hypothetical scenarios. These models consider particular attributes of the loans underlying our securities and assumptions about changes in the economic environment, such as home prices and interest rates, to predict borrower behavior and the impact on default frequency, loss severity and remaining credit enhancement. We use these models to estimate the expected cash flows (“recoverable amount”) from our securities in assessing whether it is probable that we will not collect all of the contractual amounts due. If the recoverable amount is less than the contractual principal and interest due, we may determine, based on this factor in combination with our assessment of other relevant factors, that the security is other-than-temporarily impaired. If we make that determination, the amount of other-than-temporary impairment is determined by reference to the security’s current fair value, rather than the expected cash flows of the security. We write down any other-than-temporarily impaired AFS security to its current fair value, record the difference between the amortized cost basis and the fair value as an other-than-temporary loss in our consolidated statements of operations and establish a new cost basis for the security based on the current fair value. The fair value measurement we use to determine the amount of other-than-temporary impairment to record may be less than the actual amount we expect to realize by holding the security to maturity.
 
Allowance for Loan Losses and Reserve for Guaranty Losses
 
We employ a systematic and consistently applied methodology to determine our best estimate of incurred credit losses in our guaranty book of business as of each balance sheet date. We use the same methodology to determine both our allowance for loan losses and reserve for guaranty losses, which we collectively refer to as our “combined loss reserves.” We update and refine the assumptions used in determining our loss reserves as necessary in response to new loan performance data and to reflect the current economic environment and market conditions.
 
Our models and our methods of employing assumptions in estimating the combined loss reserves have remained consistent with prior periods. As a result of the rapidly changing housing and credit market conditions during the third quarter of 2008, we have observed a more significant impact on our allowance caused by: (1) more severe estimates of the probability of default (“default rates”), our unpaid principal balance loan exposure at default and the average loss given a default (“loss severity”) relating to Alt-A loans; (2) increasing default rates on our 2005 vintage Alt-A loans; and (3) a shorter estimated period of time between the identification of a loss triggering event, such as a borrower’s loss of employment, and the actual realization of the loss, which is referred to as the loss emergence period, for higher risk loan categories, including Alt-A loans.
 
See “Consolidated Results of Operations—Credit-Related Expenses” and “Notes to Condensed Financial Statements—Note 5, Allowance for Loan Losses and Reserve for Guaranty Losses” for additional information on our loss reserves.
 
Deferred Tax Assets
 
We recognize deferred tax assets and liabilities for the future tax consequences related to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and for tax credits. In the third quarter of 2008, we recorded a non-cash charge of $21.4 billion to establish a partial deferred tax asset valuation allowance, which reduced our net deferred tax assets to $4.6 billion as of September 30, 2008. Our net deferred tax assets totaled $13.0 billion as of December 31, 2007. We evaluate our deferred tax assets for recoverability using a consistent approach that considers the relative impact of negative and positive evidence, including our historical profitability and projections of future taxable income. We are required to establish a valuation allowance for deferred tax assets and record a charge to income or stockholders’ equity if we determine, based on available evidence at the time the determination is made, that it is more likely than not that some portion or all of the deferred tax assets will not be realized. In evaluating the need for a valuation allowance, we estimate future taxable income based on management-approved business plans and ongoing tax planning strategies. This process involves significant management judgment about assumptions that are subject to change from period to period based on changes in tax laws or variances


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between our projected operating performance, our actual results and other factors. Accordingly, we have included the assessment of a deferred tax asset valuation allowance as a critical accounting policy.
 
As of September 30, 2008, we were in a cumulative book taxable loss position for more than a twelve-quarter period. For purposes of establishing a deferred tax valuation allowance, this cumulative book taxable loss position is considered significant, objective evidence that we may not be able to realize some portion of our deferred tax assets in the future. Our cumulative book taxable loss position was caused by the negative impact on our results from the weak housing and credit market conditions over the past year. These conditions deteriorated dramatically during the third quarter of 2008, causing a significant increase in our pre-tax loss for the third quarter of 2008, due in part to much higher credit losses, and downward revisions to our projections of future results. Because of the volatile economic conditions during the third quarter of 2008, our projections of future credit losses have become more uncertain.
 
As of September 30, 2008, we concluded that it was more likely than not that we would not generate sufficient taxable income in the foreseeable future to realize all of our deferred tax assets. Our conclusion was based on our consideration of the relative weight of the available evidence, including the rapid deterioration of market conditions discussed above, the uncertainty of future market conditions on our results of operations and significant uncertainty surrounding our future business model as a result of the placement of the company into conservatorship by FHFA on September 6, 2008. This negative evidence was the basis for the establishment of the partial deferred tax valuation allowance of $21.4 billion during the third quarter. We did not, however, establish a valuation allowance for the deferred tax asset related to unrealized losses recorded in AOCI on our available-for-sale securities. We believe this deferred tax amount, which totaled $4.6 billion as of September 30, 2008, is recoverable because we have the intent and ability to hold these securities until recovery of the unrealized loss amounts.
 
As discussed in “Liquidity and Capital Management—Capital Management—Capital Activity—Capital Management Actions,” the non-cash charge we recorded during the third quarter to establish the deferred tax valuation allowance was a primary driver of the reduction in our stockholders’ equity to $9.3 billion as of September 30, 2008. Our remaining deferred tax asset of $4.6 billion represented a significant portion of our stockholders’ equity as of September 30, 2008. The amount of deferred tax assets considered realizable is subject to adjustment in future periods. We will continue to monitor all available evidence related to our ability to utilize our remaining deferred tax assets. If we determine that recovery is not likely because we no longer have the intent or ability to hold our available-for-sale securities until recovery of the unrealized loss amounts, we will record an additional valuation allowance against the deferred tax assets that we estimate may not be recoverable, which would further reduce our stockholders’ equity. In addition, our income tax expense in future periods will be increased or reduced to the extent of offsetting increases or decreases to our valuation allowance.
 
See “Notes to Condensed Consolidated Financial Statements—Note 11, Income Taxes” of this report for additional information. Also, see our 2007 Form 10-K in “Notes to Consolidated Financial Statements—Note 11, Income Taxes” for detail on the components of our deferred tax assets and deferred tax liabilities as of December 31, 2007.


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CONSOLIDATED RESULTS OF OPERATIONS
 
The following discussion of our condensed consolidated results of operations is based on a comparison of our results between the three and nine months ended September 30, 2008 and the three and nine months ended September 30, 2007. You should read this section together with “Executive Summary—Outlook,” where we discuss trends and other factors that we expect will affect our future results of operations.
 
Table 2 presents a summary of our unaudited condensed consolidated results of operations for each of these periods.
 
Table 2:  Summary of Condensed Consolidated Results of Operations
 
                                                                 
    For the
    For the
             
    Three Months Ended
    Nine Months Ended
    Quarterly
    Year-to-Date
 
    September 30,     September 30,     Variance     Variance  
    2008     2007     2008     2007     $     %     $     %  
    (Dollars in millions, except per share amounts)  
 
Net interest income
  $ 2,355     $ 1,058     $ 6,102     $ 3,445     $ 1,297       123 %   $ 2,657       77 %
Guaranty fee income
    1,475       1,232       4,835       3,450       243       20       1,385       40  
Trust management income
    65       146       247       460       (81 )     (55 )     (213 )     (46 )
Fee and other income(1)
    164       217       616       751       (53 )     (24 )     (135 )     (18 )
                                                                 
Net revenues
    4,059       2,653       11,800       8,106       1,406       53       3,694       46  
Losses on certain guaranty contracts
          (294 )           (1,038 )     294       100       1,038       100  
Investment gains (losses), net(1)
    (1,624 )     (159 )     (2,618 )     43       (1,465 )     (921 )     (2,661 )     (6,188 )
Fair value losses, net(1)
    (3,947 )     (2,082 )     (7,807 )     (1,224 )     (1,865 )     (90 )     (6,583 )     (538 )
Losses from partnership investments
    (587 )     (147 )     (923 )     (527 )     (440 )     (299 )     (396 )     (75 )
Administrative expenses
    (401 )     (660 )     (1,425 )     (2,018 )     259       39       593       29  
Credit-related expenses(2)
    (9,241 )     (1,200 )     (17,833 )     (2,039 )     (8,041 )     (670 )     (15,794 )     (775 )
Other non-interest expenses(1)(3)
    (147 )     (95 )     (938 )     (259 )     (52 )     (55 )     (679 )     (262 )
                                                                 
Income (loss) before federal income taxes and extraordinary losses
    (11,888 )     (1,984 )     (19,744 )     1,044       (9,904 )     (499 )     (20,788 )     (1,991 )
Benefit (provision) for federal income taxes
    (17,011 )     582       (13,607 )     468       (17,593 )     (3,023 )     (14,075 )     (3,007 )
Extraordinary gains (losses), net of tax effect
    (95 )     3       (129 )     (3 )     (98 )     (3,267 )     (126 )     (4,200 )
                                                                 
Net income (loss)
  $ (28,994 )   $ (1,399 )   $ (33,480 )   $ 1,509     $ (27,595 )     (1,972 )%   $ (34,989 )     (2,319 )%
                                                                 
Diluted earnings (loss) per common share
  $ (13.00 )   $ (1.56 )   $ (24.24 )   $ 1.17     $ (11.44 )     (733 )%   $ (25.41 )     (2,172 )%
                                                                 
 
 
(1) Certain prior period amounts have been reclassified to conform with the current period presentation in our condensed consolidated statements of operations.
 
(2) Consists of provision for credit losses and foreclosed property expense.
 
(3) Consists of debt extinguishment gains (losses), net, minority interest in (earnings) losses of consolidated subsidiaries and other expenses.
 
Our business generates revenues from four principal sources: net interest income; guaranty fee income; trust management income; and fee and other income. Other significant factors affecting our results of operations include: fair value gains and losses; the timing and size of investment gains and losses; credit-related expenses; losses from partnership investments; administrative expenses and our effective tax rate. We provide a comparative discussion of the effect of our principal revenue sources and other significant items on our condensed consolidated results of operations for the three and nine months ended September 30, 2008 and 2007 below.


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Net Interest Income
 
Net interest income, which is the amount by which interest income exceeds interest expense, is a primary source of our revenue. Interest income consists of interest on our interest-earning assets, plus income from the accretion of discounts for assets acquired at prices below the principal value, less expense from the amortization of premiums for assets acquired at prices above principal value. Interest expense consists of contractual interest on our interest-bearing liabilities and accretion and amortization of any cost basis adjustments, including premiums and discounts, which arise in conjunction with the issuance of our debt. The amount of interest income and interest expense we recognize in the consolidated statements of operations is affected by our investment activity, our debt activity, asset yields and the cost of our debt. We expect net interest income to fluctuate based on changes in interest rates and changes in the amount and composition of our interest-earning assets and interest-bearing liabilities. Table 3 presents an analysis of our net interest income and net interest yield for the three and nine months ended September 30, 2008 and 2007.
 
As described below in “Fair Value Gains (Losses), Net,” we supplement our issuance of debt with interest rate-related derivatives to manage the prepayment and duration risk inherent in our mortgage investments. The effect of these derivatives, in particular the periodic net interest expense accruals on interest rate swaps, is not reflected in net interest income. See “Fair Value Gains (Losses), Net” for additional information.
 
Table 3:  Analysis of Net Interest Income and Yield
 
                                                 
    For the Three Months Ended September 30,  
    2008     2007  
          Interest
    Average
          Interest
    Average
 
    Average
    Income/
    Rates
    Average
    Income/
    Rates
 
    Balance(1)     Expense     Earned/Paid     Balance(1)     Expense     Earned/Paid  
    (Dollars in millions)  
 
Interest-earning assets:
                                               
Mortgage loans(2)
  $ 424,609     $ 5,742       5.41 %   $ 397,349     $ 5,572       5.61 %
Mortgage securities
    335,739       4,330       5.16       330,872       4,579       5.54  
Non-mortgage securities(3)
    58,208       381       2.56       72,075       999       5.43  
Federal funds sold and securities purchased under agreements to resell
    42,037       274       2.55       17,994       246       5.35  
Advances to lenders
    3,226       36       4.37       8,561       76       3.45  
                                                 
Total interest-earning assets
  $ 863,819     $ 10,763       4.98 %   $ 826,851     $ 11,472       5.54 %
                                                 
Interest-bearing liabilities:
                                               
Short-term debt
  $ 271,007     $ 1,677       2.42 %   $ 166,832     $ 2,400       5.63 %
Long-term debt
    560,540       6,728       4.80       613,801       8,013       5.22  
Federal funds purchased and securities sold under agreements to repurchase
    526       3       2.23       161       1       4.46  
                                                 
Total interest-bearing liabilities
  $ 832,073     $ 8,408       4.02 %   $ 780,794     $ 10,414       5.31 %
                                                 
Impact of net non-interest bearing funding
  $ 31,746               0.14 %   $ 46,057               0.29 %
                                                 
Net interest income/net interest yield(4)
          $ 2,355       1.10 %           $ 1,058       0.52 %
                                                 
 


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    For the Nine Months Ended September 30,  
    2008     2007  
          Interest
    Average
          Interest
    Average
 
    Average
    Income/
    Rates
    Average
    Income/
    Rates
 
    Balance(1)     Expense     Earned/Paid     Balance(1)     Expense     Earned/Paid  
    (Dollars in millions)  
 
Interest-earning assets:
                                               
Mortgage loans(2)
  $ 417,764     $ 17,173       5.48 %   $ 391,318     $ 16,582       5.65 %
Mortgage securities
    323,334       12,537       5.17       329,126       13,606       5.51  
Non-mortgage securities(3)
    60,771       1,459       3.15       67,595       2,763       5.39  
Federal funds sold and securities purchased under agreements to resell
    35,072       853       3.20       15,654       633       5.33  
Advances to lenders
    3,594       147       5.37       6,097       160       3.45  
                                                 
Total interest-earning assets
  $ 840,535     $ 32,169       5.10 %   $ 809,790     $ 33,744       5.55 %
                                                 
Interest-bearing liabilities:
                                               
Short-term debt
  $ 257,020     $ 5,920       3.03 %   $ 163,062     $ 6,806       5.50 %
Long-term debt
    552,343       20,139       4.86       609,018       23,488       5.14  
Federal funds purchased and securities sold under agreements to repurchase
    422       8       2.49       136       5       4.91  
                                                 
Total interest-bearing liabilities
  $ 809,785     $ 26,067       4.28 %   $ 772,216     $ 30,299       5.22 %
                                                 
Impact of net non-interest bearing funding
  $ 30,750               0.16 %   $ 37,574               0.24 %
                                                 
Net interest income/net interest yield(4)
          $ 6,102       0.98 %           $ 3,445       0.57 %
                                                 
 
 
(1) For mortgage loans, average balances have been calculated based on the average of the amortized cost amounts at the beginning of the year and at the end of each month in the period. For all other categories, average balances have been calculated based on a daily average. The average balance for the three and nine months ended September 30, 2008 for advances to lenders also has been calculated based on a daily average.
 
(2) Average balance amounts include nonaccrual loans with an average balance totaling $9.2 billion and $6.2 billion for the three months ended September 30, 2008 and 2007, respectively, and $8.7 billion and $6.0 billion for the nine months ended September 30, 2008 and 2007, respectively. Interest income includes interest income on delinquent SOP 03-3 loans purchased from MBS trusts, which totaled $166 million and $127 million for the three months ended September 30, 2008 and 2007, respectively, and $479 million and $346 million for the nine months ended September 30, 2008 and 2007, respectively. These interest income amounts include the accretion of the fair value loss recorded upon purchase of SOP 03-3 loans, which totaled $37 million and $20 million for the three months ended September 30, 2008 and 2007, respectively, and $125 million and $42 million for the nine months ended September 30, 2008 and 2007.
 
(3) Includes cash equivalents.
 
(4) We compute net interest yield by dividing annualized net interest income for the period by the average balance of total interest-earning assets during the period.
 
Net interest income of $2.4 billion for the third quarter of 2008 represented an increase of 123% over net interest income of $1.1 billion for the third quarter of 2007, driven by a 112% (58 basis points) expansion of our net interest yield to 1.10% and a 4% increase in our average interest-earning assets. Net interest income of $6.1 billion for the first nine months of 2008 represented an increase of 77% over net interest income of $3.4 billion for the first nine months of 2007, driven by a 72% (41 basis points) expansion of our net interest yield to 0.98% and a 4% increase in our average interest-earning assets.
 
Table 4 presents the total variance, or change, in our net interest income between the three and nine months ended September 30, 2008 and 2007, and the extent to which that variance is attributable to (1) changes in the volume of our interest-earning assets and interest-bearing liabilities or (2) changes in the interest rates of these assets and liabilities.

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Table 4:  Rate/Volume Analysis of Net Interest Income
 
                                                 
    For the Three Months
    For the Nine Months
 
    Ended September 30,
    Ended September 30,
 
    2008 vs. 2007     2008 vs. 2007  
    Total
    Variance Due to:(1)     Total
    Variance Due to:(1)  
    Variance     Volume     Rate     Variance     Volume     Rate  
    (Dollars in millions)  
 
Interest income:
                                               
Mortgage loans(2)
  $ 170     $ 373     $ (203 )   $ 591     $ 1,097     $ (506 )
Mortgage securities
    (249 )     67       (316 )     (1,069 )     (236 )     (833 )
Non-mortgage securities(3)
    (618 )     (165 )     (453 )     (1,304 )     (256 )     (1,048 )
Federal funds sold and securities purchased under agreements to resell
    28       205       (177 )     220       548       (328 )
Advances to lenders
    (40 )     (56 )     16       (13 )     (81 )     68  
                                                 
Total interest income
    (709 )     424       (1,133 )     (1,575 )     1,072       (2,647 )
                                                 
Interest expense:
                                               
Short-term debt
    (723 )     1,052       (1,775 )     (886 )     2,933       (3,819 )
Long-term debt
    (1,285 )     (666 )     (619 )     (3,349 )     (2,111 )     (1,238 )
Federal funds purchased and securities sold under agreements to repurchase
    2       2             3       6       (3 )
                                                 
Total interest expense
    (2,006 )     388       (2,394 )     (4,232 )     828       (5,060 )
                                                 
Net interest income
  $ 1,297     $ 36     $ 1,261     $ 2,657     $ 244     $ 2,413  
                                                 
 
 
(1) Combined rate/volume variances are allocated to both rate and volume based on the relative size of each variance.
 
(2) Please see footnote 2 in Table 3.
 
(3) Includes cash equivalents.
 
The increase in our net interest income and net interest yield for the third quarter and first nine months of 2008 was mainly driven by the reduction in short-term borrowing rates, which reduced the average cost of our debt, and a shift in our funding mix to more short-term debt. Also contributing to the lower cost of funds was our redemption of step-rate debt securities, which provided an annualized benefit to our net interest yield of approximately seven basis points for the first nine months of 2008. Instead of having a fixed rate of interest for the life of the security, step-rate debt securities provide for the interest rate to increase at predetermined rates according to a specified schedule, resulting in increased interest payments. However, the interest expense on step-rate debt securities is recognized at a constant effective rate over the term of the security. Because we paid off these securities prior to maturity, we reversed a portion of the interest expense that we had previously accrued.
 
The increase in our average interest-earning assets for the third quarter and first nine months of 2008 was attributable to an increase in our portfolio purchases during the first nine months of 2008, particularly in the second quarter of 2008, as mortgage-to-debt spreads reached historic highs. OFHEO’s reduction in our capital surplus requirement on March 1, 2008 provided us with more flexibility to take advantage of opportunities to purchase mortgage assets at attractive prices and spreads. However, since July 2008, we have experienced significant limitations on our ability to issue callable or long-term debt. Because of these limitations, we increased our portfolio at a slower rate in the third quarter of 2008 than in the second quarter and we may not be able to further increase the size of our mortgage portfolio. For a discussion of these limitations, see “Liquidity and Capital Management—Liquidity—Funding—Debt Funding Activity.”
 
Although we consider the periodic net contractual interest accruals on our interest rate swaps to be part of the cost of funding our mortgage investments, these amounts are not reflected in our net interest income and net interest yield. Instead, the net contractual interest accruals on our interest rate swaps are reflected in our condensed consolidated statements of operations as a component of “Fair value gains (losses), net.” As indicated in Table 8, we recorded net contractual interest expense on our interest rate swaps totaling $681 million and $1.0 billion for the three and nine months ended September 30, 2008, respectively, which had the economic effect of increasing our funding costs by approximately 33 basis points and 17 basis points for the three and nine months ended September 30, 2008, respectively. We recorded net contractual interest


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income on our interest rate swaps of $95 million and $193 million for the three and nine months ended September 30, 2007, respectively, which had the economic effect of reducing our funding costs by approximately 5 and 3 basis points for the respective periods.
 
Guaranty Fee Income
 
Guaranty fee income primarily consists of contractual guaranty fees related to Fannie Mae MBS held in our portfolio and held by third-party investors, adjusted for the amortization of upfront fees over the estimated life of the loans underlying the MBS and impairment of guaranty assets, net of a proportionate reduction in the related guaranty obligation and deferred profit, and impairment of buy-ups. The average effective guaranty fee rate reflects our average contractual guaranty fee rate adjusted for the impact of amortization of upfront fees and buy-up impairment. See our 2007 Form 10-K, “Notes to Consolidated Financial Statements—Note 1, Summary of Significant Accounting Policies” for a detailed description of our guaranty fee accounting.
 
Guaranty fee income is primarily affected by the amount of outstanding Fannie Mae MBS and our other guarantees and the compensation we receive for providing our guaranty on Fannie Mae MBS and for providing other guarantees. The amount of compensation we receive and the form of payment varies depending on factors such as the risk profile of the securitized loans, the level of credit risk we assume and the negotiated payment arrangement with the lender. Our payment arrangements may be in the form of an upfront payment, an ongoing payment stream from the cash flows of the MBS trusts, or a combination. We typically negotiate a contractual guaranty fee with the lender and collect the fee on a monthly basis based on the contractual fee rate multiplied by the unpaid principal balance of loans underlying a Fannie Mae MBS. In lieu of charging a higher contractual fee rate for loans with greater credit risk, we may require that the lender pay an upfront fee to compensate us for assuming the additional credit risk. We refer to this payment as a risk-based pricing adjustment. We also may adjust the monthly contractual guaranty fee rate so that the pass-through coupon rates on Fannie Mae MBS are in more easily tradable increments of a whole or half percent by making an upfront payment to the lender (“buy-up”) or receiving an upfront payment from the lender (“buy-down”).
 
As we receive monthly contractual payments for our guaranty obligation, we recognize guaranty fee income. We defer upfront risk-based pricing adjustments and buy-down payments that we receive from lenders and recognize these amounts as a component of guaranty fee income over the expected life of the underlying assets of the related MBS trusts. We record buy-up payments we make to lenders as an asset and then reduce the recorded asset over time as cash flows are received over the expected life of the underlying assets of the related MBS trusts. We assess buy-ups for other-than-temporary impairment and include any impairment recognized as a component of guaranty fee income. The extent to which we amortize upfront payments and other deferred amounts into income depends on the rate of expected prepayments, which is affected by interest rates. In general, as interest rates decrease, expected prepayment rates increase, resulting in accelerated accretion into income of deferred amounts, which increases our guaranty fee income. Conversely, as interest rates increase, expected prepayments rates decrease, resulting in slower amortization of deferred amounts. Prepayment rates also affect the estimated fair value of buy-ups. Faster than expected prepayment rates shorten the average expected life of the underlying assets of the related MBS trusts, which reduces the value of our buy-up assets and may trigger the recognition of other-than-temporary impairment.
 
Table 5 shows the components of our guaranty fee income, our average effective guaranty fee rate, and Fannie Mae MBS activity for the three and nine months ended September 30, 2008 and 2007.


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Table 5:  Guaranty Fee Income and Average Effective Guaranty Fee Rate(1)
 
                                         
    For the Three Months Ended September 30,        
    2008     2007     Amount
 
    Amount     Rate(2)     Amount     Rate(2)     Variance  
    (Dollars in millions)  
 
Guaranty fee income/average effective guaranty fee rate, excluding certain fair value adjustments and buy-up impairment
  $ 1,546       24.7 bp   $ 1,235       22.8 bp     25 %
Net change in fair value of buy-ups and guaranty assets
    (63 )     (1.0 )                 100  
Buy-up impairment
    (8 )     (0.1 )     (3 )           167  
                                         
Guaranty fee income/average effective guaranty fee rate(3)
  $ 1,475       23.6 bp   $ 1,232       22.8 bp     20 %
                                         
Average outstanding Fannie Mae MBS and other guarantees(4)
  $ 2,502,254             $ 2,163,173               16 %
Fannie Mae MBS issues(5)
    106,991               171,204               (38 )
 
                                         
    For the Nine Months Ended September 30,        
    2008     2007     Amount
 
    Amount     Rate(2)     Amount     Rate(2)     Variance  
    (Dollars in millions)  
 
Guaranty fee income/average effective guaranty fee rate, excluding certain fair value adjustments and buy-up impairment
  $ 4,723       25.8 bp   $ 3,439       21.9 bp     37 %
Net change in fair value of buy-ups and guaranty assets
    151       0.8       19       0.1       695  
Buy-up impairment
    (39 )     (0.2 )     (8 )           388  
                                         
Guaranty fee income/average effective guaranty fee rate(3)
  $ 4,835       26.4 bp   $ 3,450       22.0 bp     40 %
                                         
Average outstanding Fannie Mae MBS and other guarantees(4)
  $ 2,438,143             $ 2,090,322               17 %
Fannie Mae MBS issues(5)
    453,346               453,506                
 
 
(1) Losses recognized at inception on certain guaranty contracts for periods prior to January 1, 2008 are excluded from guaranty fee income and the average effective guaranty fee rate; however, as described in footnote 3 below, the accretion of these losses into income over time is included in our guaranty fee income and average effective guaranty fee rate.
 
(2) Presented in basis points and calculated based on annualized amounts of our guaranty fee income components divided by average outstanding Fannie Mae MBS and other guarantees for each respective period.
 
(3) Losses recognized at inception on certain guaranty contracts for periods prior to January 1, 2008, which are excluded from guaranty fee income, are recorded as a component of our guaranty obligation. We accrete a portion of our guaranty obligation, which includes these losses, into income each period in proportion to the reduction in the guaranty asset for payments received. This accretion increases our guaranty fee income and reduces the related guaranty obligation. Effective January 1, 2008, we no longer recognize losses at inception of our guaranty contracts due to a change in our method for measuring the fair value of our guaranty obligations. Although we will no longer recognize losses at inception of our guaranty contracts, we will continue to accrete previously recognized losses into our guaranty fee income over the remaining life of the mortgage loans underlying the Fannie Mae MBS.
 
(4) Other guarantees includes $32.2 billion and $41.6 billion as of September 30, 2008 and December 31, 2007, respectively, and $35.5 billion and $19.7 billion as of September 30, 2007 and December 31, 2006, respectively, related to long-term standby commitments we have issued and credit enhancements we have provided.
 
(5) Reflects unpaid principal balance of Fannie Mae MBS issued and guaranteed by us, including mortgage loans held in our portfolio that we securitized during the period and Fannie Mae MBS issued during the period that we acquired for our portfolio.
 
The 20% increase in guaranty fee income for the third quarter of 2008 over the third quarter of 2007 resulted from a 16% increase in average outstanding Fannie Mae MBS and other guarantees, and a 4% increase in the average effective guaranty fee rate to 23.6 basis points from 22.8 basis points. The 40% increase in guaranty fee income for the first nine months of 2008 over the first nine months of 2007 resulted from a 17% increase in average outstanding Fannie Mae MBS and other guarantees, and a 20% increase in the average effective guaranty fee rate to 26.4 basis points from 22.0 basis points.


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The increase in average outstanding Fannie Mae MBS and other guarantees reflected our higher market share of mortgage-related securities issuances during the first nine months of 2008, as compared to the first nine months of 2007. We experienced this market share increase in large part due to the near-elimination of competition from issuers of private-label mortgage-related securities.
 
The increase in our average effective guaranty fee rate was affected by guaranty fee pricing changes designed to price for the current risks in the housing market. These pricing changes include an adverse market delivery charge of 25 basis points for all loans delivered to us, which became effective March 1, 2008. The impact of our guaranty fee pricing changes was partially offset by a shift in the composition of our guaranty book of business to a greater proportion of higher-quality, lower risk and lower guaranty fee mortgages, as we reduced our acquisitions of higher risk, higher fee product categories, such as Alt-A loans. Our average charged guaranty fee on new single-family business was 31.9 basis points and 28.1 basis points for the third quarter and first nine months of 2008, respectively, compared with 31.4 basis points and 28.7 basis points for the third quarter and first nine months of 2007, respectively. The average charged guaranty fee on our new single-family business represents the average contractual fee rate for our single-family guaranty arrangements plus the recognition of any upfront cash payments ratably over an estimated life of four years.
 
The increase in our average effective guaranty fee rate for the first nine months of 2008 was also driven by the accelerated recognition of deferred amounts into income as interest rates were generally lower in the first nine months of 2008 than the first nine months of 2007. Our guaranty fee income also includes accretion of deferred amounts on guaranty contracts where we recognized losses at the inception of the contract, which totaled an estimated $131 million and $555 million for the three and nine months ended September 30, 2008, compared with $144 million and $327 million for the three and nine months ended September 30, 2007. See “Part II—Item 7—MD&A—Critical Accounting Policies and Estimates” of our 2007 Form 10-K for additional information on our accounting for these losses and the impact on our financial statements.
 
Trust Management Income
 
Trust management income consists of the fees we earn as master servicer, issuer and trustee for Fannie Mae MBS. We derive these fees from the interest earned on cash flows between the date of remittance of mortgage and other payments to us by servicers and the date of distribution of these payments to MBS certificateholders, which we refer to as float income. Trust management income decreased to $65 million and $247 million for the third quarter and first nine months of 2008, respectively, from $146 million and $460 million for the third quarter and first nine months of 2007, respectively. The decrease during each period was attributable to significantly lower short-term interest rates during the first nine months of 2008 relative to the first nine months of 2007, which reduced the amount of float income we earned.
 
Fee and Other Income
 
Fee and other income consists of transaction fees, technology fees and multifamily fees. Fee and other income decreased to $164 million and $616 million for the third quarter and first nine months of 2008, respectively, from $217 million and $751 million for the third quarter and first nine months of 2007, respectively. The decrease during each period was primarily attributable to lower multifamily fees due to a reduction in multifamily loan liquidations for the first nine months of 2008.
 
Losses on Certain Guaranty Contracts
 
Effective January 1, 2008 with our adoption of SFAS 157, we no longer recognize losses or record deferred profit in our consolidated financial statements at inception of our guaranty contracts for MBS issued subsequent to December 31, 2007 because the estimated fair value of the guaranty obligation at inception now equals the estimated fair value of the total compensation received. For further discussion of this change, see “Critical Accounting Policies and Estimates—Fair Value of Financial Instruments—Change in Measuring the Fair Value of Guaranty Obligations” and “Notes to Condensed Consolidated Financial Statements—Note 2, Summary of Significant Accounting Policies.”


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We recorded losses at inception on certain guaranty contracts totaling $294 million and $1.0 billion for the three and nine months ended September 30, 2007, respectively. These losses reflected the increase in the estimated market risk premium that a market participant would require to assume our guaranty obligations due to the decline in home prices and deterioration in credit conditions. We will continue to accrete these losses into income over time as part of the accretion of the related guaranty obligation on contracts where we recognized losses at inception of the contract. See “Notes to Condensed Consolidated Financial Statements—Note 7, Financial Guarantees” for additional information.
 
Investment Gains (Losses), Net
 
Investment losses, net includes other-than-temporary impairment on available-for-sale securities, lower-of-cost-or-market adjustments on held for sale loans, gains and losses recognized on the securitization of loans or securities from our portfolio and the sale of available-for-sale securities and other investment losses. Investment gains and losses may fluctuate significantly from period to period depending upon our portfolio investment and securitization activities and changes in market and credit conditions that may result in other-than-temporary impairment. We summarize the components of investment gains (losses), net for the three and nine months ended September 30, 2008 and 2007 below in Table 6 and discuss significant changes in these components between periods.
 
Table 6:  Investment Gains (Losses), Net
 
                                 
    For the
    For the
 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2008     2007     2008     2007  
    (Dollars in millions)  
 
Other-than-temporary impairment on available-for-sale securities(1)
  $ (1,843 )   $ (75 )   $ (2,405 )   $ (78 )
Lower-of-cost-or-market adjustments on held for sale loans
    5       3       (306 )     (115 )
Gains (losses) on Fannie Mae portfolio securitizations, net
    17       (65 )     (8 )     (27 )
Gains on sale of available-for-sale securities, net
    293       47       306       373  
Other investment losses, net
    (96 )     (69 )     (205 )     (110 )
                                 
Investment gains (losses), net
  $ (1,624 )   $ (159 )   $ (2,618 )   $ 43  
                                 
 
 
(1) Excludes other-than-temporary impairment on guaranty assets and buy-ups as these amounts are recognized as a component of guaranty fee income. Refer to Table 5: Guaranty Fee Income and Average Effective Guaranty Fee Rate.
 
The increase in investment losses for the third quarter and first nine months of 2008 over the third quarter and first nine months of 2007 was primarily attributable to the significant increase in other-than-temporary impairment on available-for-sale securities, principally for Alt-A and subprime private-label securities. We recognized other-than-temporary impairment on these securities of $1.8 billion and $2.4 billion in the third quarter and first nine months of 2008, respectively, reflecting a reduction in expected cash flows due to an increase in expected defaults and loss severities on the mortgage loans underlying these securities. See “Critical Accounting Policies and Estimates—Other-than-temporary Impairment of Investment Securities” and “Consolidated Balance Sheet Analysis—Trading and Available-for-Sale Investment Securities—Investments in Private-Label Mortgage Related Securities” for additional information on impairment of our investment securities.
 
Fair Value Gains (Losses), Net
 
Fair value gains and losses, net consists of (1) derivatives fair value gains and losses, including gains and losses on derivatives designated as accounting hedges; (2) trading securities gains and losses; (3) fair value adjustments to the carrying value of mortgage assets designated for hedge accounting that are attributable to changes in interest rates; (4) foreign exchange gains and losses on our foreign-denominated debt; and (5) fair value gains and losses on certain debt securities carried at fair value. By presenting these items together in our


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condensed consolidated results of operations, we are able to show the net impact of mark-to-market adjustments that generally result in offsetting gains and losses attributable to changes in interest rates.
 
Beginning in mid-April 2008, we implemented fair value hedge accounting with respect to a portion of our derivatives to hedge, for accounting purposes, the interest rate risk related to some of our mortgage assets, including mortgage loans classified as held for investment. Fair value hedge accounting allows us to offset the fair value gains or losses on some of our derivative instruments against the corresponding fair value losses or gains attributable to changes in interest rates on the specific hedged mortgage assets. We implemented this hedging strategy to reduce the level of volatility in our earnings attributable to changes in interest rates for our interest rate risk management derivatives. However, our application of hedge accounting does not affect volatility in our financial results that is attributable to changes in credit spreads.
 
The provisions of the conservatorship and Treasury agreements caused us to change our focus from reducing the volatility in our earnings attributable to changes in interest rates to maintaining a positive net worth. As a result of this change, we modified our hedge accounting strategy during the third quarter of 2008 to discontinue the application of hedge accounting for multifamily mortgage loans. Applying hedge accounting to these loans requires that we record in earnings changes in fair value attributable to changes in interest rates. These fair value changes offset some of the volatility in our earnings caused by fluctuations in the fair value of our derivatives. However, recording fair value adjustments on these loans introduces an additional element of volatility in our net worth. By discontinuing hedge accounting for these loans, we will account for these loans at amortized cost and no longer record changes in the fair value in earnings. We believe this change eliminates one factor that causes volatility in our net worth.
 
We generally expect that gains and losses on our trading securities, to the extent they are attributable to changes in interest rates, will offset a portion of the losses and gains on our derivatives because changes in the fair value of our trading securities typically move inversely to changes in the fair value of our derivatives. The fair value of our trading securities, however, may not always move inversely to changes in the fair value of our derivatives because the fair values of these financial instruments are affected not only by interest rates, but also by other factors such as spreads. Consequently, the gains and losses on our trading securities may not fully offset losses and gains on our derivatives.
 
We seek to eliminate our exposure to fluctuations in foreign exchange rates by entering into foreign currency swaps that effectively convert debt denominated in a foreign currency to debt denominated in U.S. dollars. The foreign currency exchange gains and losses on our foreign-denominated debt are offset in part by corresponding losses and gains on foreign currency swaps.
 
Table 7 summarizes the components of fair value gains (losses), net for the three and nine months ended September 30, 2008 and 2007. We experienced a significant increase in fair value losses for the third quarter and first nine months of 2008, compared with the same prior year periods. The increased losses were driven by: (1) a decline in interest rates, which resulted in losses on our derivatives and gains on our hedged mortgage assets; (2) the significant widening of spreads, which resulted in losses on our trading securities; and (3) the distressed condition of several financial institutions, which resulted in significant write-downs of some of our non-mortgage investments. We provide additional information below on the most significant components of the fair value gains (losses), net line item.


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Table 7:  Fair Value Gains (Losses), Net
 
                                 
    For the
    For the
 
    Three Months
    Nine Months
 
    Ended
    Ended
 
    September 30,     September 30,  
    2008     2007     2008     2007  
    (Dollars in millions)  
 
Derivatives fair value losses, net(1)
  $ (3,302 )   $ (2,244 )   $ (4,012 )   $ (891 )
Trading securities gains (losses) net(2)
    (2,934 )     295       (5,126 )     (145 )
Hedged mortgage assets gains, net(3)
    2,028             1,225        
                                 
Fair value losses on derivatives, trading securities and hedged mortgage assets, net
    (4,208 )     (1,949 )     (7,913 )     (1,036 )
Debt foreign exchange gains (losses), net
    227       (133 )     58       (188 )
Debt fair value gains, net
    34             48        
                                 
Fair value losses, net
  $ (3,947 )   $ (2,082 )   $ (7,807 )   $ (1,224 )
                                 
 
 
(1) Includes losses of approximately $104 million for the three and nine months ended September 30, 2008, which resulted from the termination of our derivative contracts with a subsidiary of Lehman Brothers.
 
(2) Includes trading losses of $559 million recorded during the third quarter of 2008, which resulted from the write-down to fair value of our investment in corporate debt securities issued by Lehman Brothers.
 
(3) Represents adjustments to the carrying value of mortgage assets designated for hedge accounting that are attributable to changes in interest rates.
 
Derivatives Fair Value Gains (Losses), Net
 
Derivative instruments are an integral part of our strategy in managing interest rate risk. We supplement our issuance of debt with derivative instruments to further reduce duration and prepayment risks. We are generally an end user of derivatives and our principal purpose in using derivatives is to manage our aggregate interest rate risk profile within prescribed risk parameters. We generally only use derivatives that are highly liquid and relatively straightforward to value.
 
We consider the cost of derivatives used in our management of interest rate risk to be an inherent part of the cost of funding and hedging our mortgage investments and to be economically similar to the interest expense that we recognize on the debt we issue to fund our mortgage investments. For example, by combining a pay-fixed interest rate swap with short-term floating-rate debt, we can achieve the economic effect of converting short-term floating-rate debt into long-term fixed-rate debt. However, because we do not apply hedge accounting, the net contractual interest accrual on the pay-fixed swap would be reflected in “Derivatives fair value gains (losses), net” instead of as a component of interest expense. If we instead issued long-term fixed rate debt to achieve the same economic effect, the interest on the debt would be reflected as a component of interest expense. We provide a more detailed discussion of our use of derivatives in “Risk Management—Interest Rate Risk Management and Other Market Risks—Interest Rate Risk Management Strategies—Derivatives Activity.”
 
Table 8 presents, by type of derivative instrument, the fair value gains and losses on our derivatives for the three and nine months ended September 30, 2008 and 2007. Table 8 also includes an analysis of the components of derivatives fair value gains and losses attributable to net contractual interest accruals on our interest rate swaps, the net change in the fair value of terminated derivative contracts through the date of termination and the net change in the fair value of outstanding derivative contracts. The 5-year swap interest rate, which is shown below in Table 8, is a key reference interest rate that affects the fair value of our derivatives.


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Table 8:  Derivatives Fair Value Gains (Losses), Net
 
                                 
    For the
    For the
 
    Three Months
    Nine Months
 
    Ended September 30,     Ended September 30,  
    2008     2007     2008     2007  
    (Dollars in millions)  
 
Risk management derivatives:
                               
Swaps:
                               
Pay-fixed
  $ (9,492 )   $ (7,500 )   $ (9,605 )   $ (1,780 )
Receive-fixed
    5,417       3,834       7,117       956  
Basis
    (145 )     90       (213 )     (35 )
Foreign currency(1)
    (145 )     140       (19 )     97  
Swaptions:
                               
Pay-fixed
    (159 )     (237 )     (78 )     32  
Receive-fixed
    1,218       1,460       (1,008 )     (199 )
Interest rate caps
    (1 )     (3 )     2       5  
Other(2)(3)
    (61 )     3       (10 )     4  
                                 
Total risk management derivatives fair value losses, net
    (3,368 )     (2,213 )     (3,814 )     (920 )
Mortgage commitment derivatives fair value gains (losses), net
    66       (31 )     (198 )     29  
                                 
Total derivatives fair value losses, net
  $ (3,302 )   $ (2,244 )   $ (4,012 )   $ (891 )
                                 
Risk management derivatives fair value gains (losses) attributable to:
                               
Net contractual interest income (expense) on interest rate swaps
  $ (681 )   $ 95     $ (1,011 )   $ 193  
Net change in fair value of terminated derivative contracts from end of prior period to date of termination(3)
    (310 )     (50 )     (275 )     (187 )
Net change in fair value of outstanding derivative contracts, including derivative contracts entered into during the period
    (2,377 )     (2,258 )     (2,528 )     (926 )
                                 
Risk management derivatives fair value losses, net(4)
  $ (3,368 )   $ (2,213 )   $ (3,814 )   $ (920 )
                                 
 
                 
    2008     2007  
 
5-year swap interest rate:
               
As of January 1
    4.19 %     5.10 %
As of March 31
    3.31       4.99  
As of June 30
    4.26       5.50  
As of September 30
    4.11       4.87  
 
 
(1) Includes the effect of net contractual interest income of approximately $6 million and interest expense of $16 million for the three months ended September 30, 2008 and 2007, respectively, and interest income of $9 million and interest expense of $50 million for the nine months ended September 30, 2008 and 2007, respectively. The change in fair value of foreign currency swaps excluding this item resulted in a net loss of $151 million and a net gain of $156 million for the three months ended September 30, 2008 and 2007, respectively, and a net loss of $28 million and a net gain of $147 million for the nine months ended September 30, 2008 and 2007, respectively.
 
(2) Includes MBS options, swap credit enhancements and mortgage insurance contracts.
 
(3) Includes losses of approximately $104 million for the three and nine months ended September 30, 2008, which resulted from the termination of our derivative contracts with a subsidiary of Lehman Brothers.
 
(4) Reflects net derivatives fair value losses, excluding mortgage commitments, recognized in the condensed consolidated statements of operations.
 
The derivatives fair value losses of $3.3 billion for the third quarter of 2008, which includes $2.2 billion of losses on pay-fixed swaps designated as fair value hedges, reflected the combined impact of a decrease in swap interest rates during the quarter and time decay associated with our purchased options, which was partially offset by an increase in value due to an increase in implied volatility during the quarter. The 5-year


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swap interest rate fell by 15 basis points to 4.11% as of September 30, 2008 from 4.26% as of June 30, 2008. This decrease in swap interest rates resulted in fair value losses on our pay-fixed swaps that exceeded the fair value gains on our receive-fixed swaps. The derivatives fair value losses of $2.2 billion for the third quarter of 2007 were attributable to a decrease in swap interest rates during the quarter, which resulted in fair value losses on our pay-fixed swaps that more than offset the fair value gains on our receive-fixed swaps.
 
The derivatives fair value losses of $4.0 billion for the first nine months of 2008 were largely attributable to losses resulting from the decrease in interest rates, the time decay of our purchased options and rebalancing activity. The derivatives fair value losses of $891 million for the first nine months of 2007 were largely attributable to a decrease in swap interest rates during the third quarter of 2007, which resulted in fair value losses on our interest rate swaps that were partially offset by fair value gains on our option-based derivatives.
 
Although we recorded fair value losses on our derivatives for the third quarter and first nine months of 2008, these losses were partially offset by gains on mortgage assets designated for hedge accounting as shown in Table 7. Because derivatives are an important part of our interest rate risk management, it is important to evaluate the impact of our derivatives in the context of our overall interest rate risk profile and in conjunction with the other offsetting mark-to-market gains and losses presented in Table 7. For additional information on our interest rate risk management strategy and our use of derivatives, see “Risk Management—Interest Rate Risk Management and Other Market Risks—Interest Rate Risk Management Strategies.” Also see “Consolidated Balance Sheet Analysis—Derivative Instruments” for a discussion of the effect of derivatives on our condensed consolidated balance sheets.
 
Trading Securities Gains (Losses), Net
 
Our portfolio of trading securities increased to $98.7 billion as of September 30, 2008, from $64.0 billion as of December 31, 2007. We recorded net losses on trading securities of $2.9 billion and $5.1 billion for the third quarter and first nine months of 2008, respectively. These losses were due in part to the significant widening of spreads, particularly related to private-label mortgage-related securities backed by Alt-A and subprime loans and commercial mortgage-backed securities (“CMBS”) backed by multifamily mortgage loans. These losses were also due to significant declines in the market value of the non-mortgage securities in our cash and other investments portfolio during the third quarter of 2008 resulting from the financial market crisis. Of the $1.5 billion in net trading losses on the non-mortgage securities in our cash and other investments portfolio, approximately $892 million related to investments in corporate debt securities issued by Lehman Brothers, Wachovia Corporation, Morgan Stanley and American International Group, Inc. (referred to as AIG). Our exposure to Lehman Brothers accounted for $559 million of the $892 million in losses.
 
In comparison, we recorded net gains on trading securities of $295 million for the third quarter of 2007, attributable to a decline in interest rates during the quarter, and net losses of $145 million for the first nine months of 2007, reflecting the combined effect of an increase in our portfolio of trading securities and a decrease in the fair value of these securities due to a widening of credit spreads during the period.
 
We provide additional information on our trading and available-for-sale securities in “Consolidated Balance Sheet Analysis—Trading and Available-for-Sale Investment Securities” and disclose the sensitivity of changes in the fair value of our trading securities to changes in interest rates in “Risk Management—Interest Rate Risk Management and Other Market Risks—Interest Rate Risk Metrics.”
 
Hedged Mortgage Assets Gains (Losses), Net
 
Our hedge accounting relationships during the third quarter of 2008 consisted of pay-fixed interest rate swaps designated as fair value hedges of changes in the fair value, attributable to changes in the LIBOR benchmark interest rate, of specified mortgage assets. As of September 30, 2008, we had a notional amount of $15.5 billion of pay-fixed swaps designated as fair value hedges of specified mortgage assets. We include changes in fair value of hedged mortgage assets attributable to changes in the benchmark interest rate in our assessment of hedge effectiveness. These fair value accounting hedges resulted in gains on the hedged mortgage assets of $2.0 billion and $1.2 billion for the three and nine months ended September 30, 2008, respectively, which were offset by losses of $2.1 billion and $1.3 billion, respectively, on the pay-fixed swaps


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designated as hedging instruments excluding valuation changes due to the passage of time. The losses on these pay-fixed swaps are included as a component of derivatives fair value gains (losses), net. We also record as a component of derivatives fair value gains (losses) the ineffectiveness, or the portion of the change in the fair value of our derivatives that was not effective in offsetting the change in the fair value of the designated hedged mortgage assets. We had losses of $101 million and $115 million for the third quarter and first nine months of 2008, respectively, attributable to ineffectiveness of our fair value hedges. We provide additional information on our application of hedge accounting in “Notes to Condensed Consolidated Financial Statements, Note 2—Summary of Significant Accounting Policies” and “Note 10—Derivative Instruments and Hedging Activities.”
 
Losses from Partnership Investments
 
Losses from partnership investments increased to $587 million and $923 million for the third quarter and first nine months of 2008, respectively, from $147 million and $527 million for the third quarter and first nine months of 2007. The increase in losses was primarily due to an impairment charge of $245 million on our low income housing tax credit, or LIHTC, partnership investments that we recorded during the third quarter of 2008. Our decision in the third quarter of 2008 to establish a deferred tax asset valuation allowance was indicative of our potential inability to realize the future tax benefits by our LIHTC partnership investments. As a result, we determined that the potential loss on the carrying value of these investments was other than temporary. Accordingly, we recorded other-than-temporary impairment in the third quarter of 2008 on our LIHTC partnership investments that had a carrying value that exceeded the fair value. In addition, we experienced an increase in losses on our investments in rental and for-sale affordable housing.
 
Administrative Expenses
 
Administrative expenses include ongoing operating costs, such as salaries and employee benefits, professional services, occupancy costs and technology expenses. Administrative expenses decreased to $401 million and $1.4 billion for the third quarter and first nine months of 2008, respectively, from $660 million and $2.0 billion for the third quarter and first nine months of 2007, respectively, reflecting significant reductions in restatement and related regulatory expenses and a reduction in our ongoing operating costs due to efforts we undertook in 2007 to increase productivity and lower our administrative costs. In addition, because our corporate goals for 2008 were not met, in the third quarter of 2008 we reversed amounts that we had previously accrued for 2008 bonuses, which reduced our administrative expenses for the quarter and for the first nine months of 2008.
 
Pension and other postretirement benefit expenses included in our administrative expenses totaled $10 million and $47 million for the third quarter and first nine months of 2008, respectively, compared with $39 million and $91 million for the third quarter and first nine months of 2007, respectively. We made contributions of $9 million to fund our nonqualified pension plans and other postretirement benefit plans for the first nine months of 2008, and we anticipate contributing an additional $4 million in the fourth quarter of 2008 to fund these plans. For our qualified pension plan, the plan assets exceeded the projected benefit obligation as of December 31, 2007, reflecting a funding surplus of $44 million. The current funding policy for our qualified pension plan is to contribute an amount equal to the required minimum contribution under the Employee Retirement Income Security Act of 1974 (“ERISA”) and to maintain a funded status of 105% of the current liability as of January 1 of each year. Because the criteria of our funding policy were met as of December 31, 2007, our most recent measurement date, we did not expect to make a contribution during 2008 and as such, had not made a contribution to our qualified pension plan during the nine month period ended September 30, 2008. However, in light of the extreme market volatility and recent dramatic decline in the global equity markets, we determined in October 2008 that a review of the value of our qualified pension plan assets and the funded status should be completed prior to our next annual valuation. During our review, we determined that plan assets would likely be below our funding target as of our next measurement date. Accordingly, in November 2008, consistent with our funding policy, we elected to make a voluntary contribution of $80 million to our qualified pension plan for 2008 to offset some of the recent investment losses. We will re-


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evaluate the funded status at year-end to determine if additional contributions are needed under our funding policy.
 
We disclose the key actuarial assumptions for our principal employee retirement benefit plans in our 2007 Form 10-K in “Notes to Consolidated Financial Statements—Note 14, Employee Retirement Benefits.” Also see “Notes to Condensed Consolidated Financial Statements, Note 13—Employee Retirement Benefits” for additional information on our retirement benefit plans. As disclosed in note 14 of our 2007 Form 10-K, we made some changes to our employee benefit plans in the fourth quarter of 2007, including freezing the benefits under our defined benefit pension plans for active employees who did not meet certain grandfather provisions as of December 31, 2007 and terminating plan coverage for employees hired on or after December 31, 2007. We continue to accrue benefits under these plans for employees who met the grandfather provisions as of December 31, 2007.
 
Credit-Related Expenses
 
Credit-related expenses included in our condensed consolidated statements of operations consist of the provision for credit losses and foreclosed property expense. We detail the components of our credit-related expenses in Table 9. The substantial increase in our credit-related expenses for the third quarter and first nine months of 2008, compared with the third quarter and first nine months of 2007, was attributable to significant increases in our provision for credit losses and foreclosed property expense, reflecting continued building of our loss reserves and increases in the level of net charge-offs due to the severe deterioration in the housing market and worsening economic conditions.
 
Table 9:  Credit-Related Expenses
 
                                 
          For the
 
    For the
    Nine Months
 
    Three Months Ended
    Ended
 
    September 30,     September 30,  
    2008     2007     2008     2007  
    (Dollars in millions)  
 
Provision for credit losses attributable to guaranty book of business
  $ 8,244     $ 417     $ 15,171     $ 965  
Provision for credit losses attributable to SOP 03-3 and HomeSaver Advance fair value losses
    519       670       1,750       805  
                                 
Total provision for credit losses(1)
    8,763       1,087       16,921       1,770  
Foreclosed property expense
    478       113       912       269  
                                 
Credit-related expenses
  $ 9,241     $ 1,200     $ 17,833     $ 2,039  
                                 
 
 
(1) Reflects total provision for credit losses reported in Table 10 below under “Combined loss reserves.”
 
Provision Attributable to Guaranty Book of Business
 
Our allowance for loan losses and reserve for guaranty losses, which we collectively refer to as our combined loss reserves, provide for probable credit losses inherent in our guaranty book of business as of each balance sheet date. The change in our combined loss reserves each period is driven by the provision for credit losses recognized in our condensed consolidated statements of operations and the net charge-offs recorded against our loss reserves. Table 10 below summarizes changes in our combined loss reserves for the three and nine months ended September 30, 2008 and 2007.


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Table 10:  Allowance for Loan Losses and Reserve for Guaranty Losses (Combined Loss Reserves)
 
                                 
    For the
    For the
 
    Three Months
    Nine Months
 
    Ended September 30,     Ended September 30,  
    2008     2007     2008     2007  
    (Dollars in millions)  
 
Changes in loss reserves:
                               
Allowance for loan losses:
                               
Beginning balance
  $ 1,476     $ 337     $ 698     $ 340  
Provision for credit losses
    1,120       148       2,544       238  
Charge-offs(1)(2)
    (829 )     (115 )     (1,603 )     (241 )
Recoveries
    36       25       164       58  
                                 
Ending balance(3)
  $ 1,803     $ 395     $ 1,803     $ 395  
                                 
Reserve for guaranty losses:
                               
Beginning balance
  $ 7,450     $ 821     $ 2,693     $ 519  
Provision for credit losses
    7,643       939       14,377       1,532  
Charge-offs(2)(4)
    (1,369 )     (757 )     (3,395 )     (1,078 )
Recoveries
    78       9       127       39  
                                 
Ending balance
  $ 13,802     $ 1,012     $ 13,802     $ 1,012  
                                 
Combined loss reserves:
                               
Beginning balance
  $ 8,926     $ 1,158     $ 3,391     $ 859  
Provision for credit losses
    8,763       1,087       16,921       1,770  
Charge-offs(1)(2)(4)
    (2,198 )     (872 )     (4,998 )     (1,319 )
Recoveries
    114       34       291       97  
                                 
Ending balance(3)
  $ 15,605     $ 1,407     $ 15,605     $ 1,407  
                                 
 
                 
    As of  
    September 30,
    December 31,
 
    2008     2007  
 
Allocation of combined loss reserves:
               
Balance at end of each period attributable to:
               
Single-family
  $ 15,528     $ 3,318  
Multifamily
    77       73  
                 
Total
  $ 15,605     $ 3,391  
                 
Single-family and multifamily loss reserve ratios:(5)
               
Single-family loss reserves as % of single-family guaranty book of business
    0.56 %     0.13 %
Multifamily loss reserves as % of multifamily guaranty book of business
    0.05       0.05  
                 
Combined loss reserves as a percentage of:
               
Total guaranty book of business
    0.53       0.12  
Total nonperforming loans(6)
    24.52       9.47  
 
 
(1) Includes accrued interest of $229 million and $32 million for the three months ended September 30, 2008 and 2007, respectively, and $468 million and $84 million for the nine months ended September 30, 2008 and 2007, respectively.
 
(2) Includes charges recorded for our HomeSaver Advance initiative of $171 million and $294 million for the three and nine months ended September 30, 2008, respectively.
 
(3) Includes $108 million and $35 million as of September 30, 2008 and 2007, respectively, for acquired loans subject to the application of SOP 03-3.
 
(4) Includes charges recorded at the date of acquisition of $348 million and $670 million for the three months ended September 30, 2008 and 2007, respectively, and $1.5 billion and $805 million for the nine months ended


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September 30, 2008 and 2007, respectively, for acquired loans subject to the application of SOP 03-3 where the acquisition cost exceeded the fair value of the acquired loan.
 
(5) Represents loss reserves amount attributable to each loan type as a percentage of the guaranty book of business for each loan type.
 
(6) Loans are classified as nonperforming at the earlier of when payment of principal and interest is three months or more past due according to the loan’s contractual terms (unless we have recourse against the seller of the loan in the event of default) or when, in our opinion, collectability of interest or principal on the loan is not reasonably assured. See Table 44: Nonperforming Single-Family and Multifamily Loans for detail on nonperforming loans as of September 30, 2008 and December 31, 2007.
 
We have continued to build our combined loss reserves through provisions that have been well in excess of our charge-offs. The provision for credit losses attributable to our guaranty book of business of $8.3 billion and $15.2 billion for the third quarter and first nine months of 2008, respectively, exceeded net charge-offs of $1.6 billion and $3.0 billion, respectively, reflecting an incremental build in our combined loss reserves of $6.7 billion for the third quarter of 2008 and $12.2 billion for the first nine months of 2008. In comparison, we recorded a provision for credit losses attributable to our guaranty book of business of $417 million and $965 million for the third quarter and first nine months of 2007, respectively. As a result of our higher loss provisioning levels, we have substantially increased our combined loss reserves both in absolute terms and as a percentage of our guaranty book of business, to $15.6 billion, or 0.53% of our guaranty book of business, as of September 30, 2008, from $3.4 billion, or 0.12% of our guaranty book of business, as of December 31, 2007.
 
The increase in our loss provisioning levels and combined loss reserves reflects our current estimate of inherent losses in our guaranty book of business as of September 30, 2008. The continued decline in home prices has resulted in higher delinquencies and defaults and an increase in the average loan loss severity or charge-off per default. As a result of the rapidly changing housing and credit market conditions during the third quarter of 2008, we have observed a more significant impact on our allowance caused by: (1) more severe estimates of default rates, our unpaid principal balance loan exposure at default and loss severity relating to Alt-A loans; (2) increasing default rates on our 2005 vintage Alt-A loans; and (3) a shorter estimated period of time between the identification of a loss triggering event, such as a borrower’s loss of employment, and the actual realization of the loss, which is referred to as the loss emergence period, for higher risk loan categories, including Alt-A loans.
 
Our conventional single-family serious delinquency rate has increased to 1.72% as of September 30, 2008, from 0.98% as of December 31, 2007 and 0.78% as of September 30, 2007. The average default rate and loan loss charge-off severity, excluding fair value losses related to SOP 03-3 loans, was 0.19% and 28%, respectively, for the third quarter of 2008, compared with 0.09% and 10% for the third quarter of 2007. These worsening credit performance trends have been most notable in certain states, certain higher risk loan categories and our 2006 and 2007 loan vintages. The Midwest, which has experienced prolonged economic weakness, and California, Florida, Arizona and Nevada, which previously experienced rapid home price increases and are now experiencing steep home price declines, have accounted for a disproportionately large share of our seriously delinquent loans and charge-offs. Our Alt-A book, particularly the 2006 and 2007 loan vintages, has exhibited early stage payment defaults and represented a disproportionate share of our seriously delinquent loans and charge-offs for the first nine months of 2008.
 
Provision Attributable to SOP 03-3 and HomeSaver Advance Fair Value Losses
 
“SOP 03-3” refers to the American Institute of Certified Public Accountants Statement of Position No. 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer. SOP 03-3 is an accounting rule requiring that, when we purchase delinquent loans from MBS trusts that are within its scope, we record our net investment in these loans at the lower of the acquisition cost of the loan or the estimated fair value at the date of purchase. To the extent the acquisition cost exceeds the estimated fair value, we record a SOP 03-3 fair value loss charge-off against the “Reserve for guaranty losses” at the time we acquire the loan.
 
We introduced HomeSaver Advance in the first quarter of 2008. HomeSaver Advance, which serves as a loss mitigation tool earlier in the delinquency cycle than a modification can be offered due to our MBS trust


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constraints, allows borrowers to cure their payment defaults without requiring modification of their mortgage loans. HomeSaver Advance allows servicers to provide qualified borrowers with a 15-year unsecured personal loan in an amount equal to all past due payments relating to their mortgage loan, up to the lesser of $15,000 or 15% of the unpaid principal balance of the delinquent first lien loan. Because HomeSaver Advance does not require modification of the first lien loan, we are not required to purchase the delinquent loans from the MBS trusts. We record HomeSaver Advance loans at their estimated fair value at the date of purchase of these loans from servicers, and, to the extent the acquisition cost exceeds the estimated fair value, we record a HomeSaver fair value loss charge-off against the “Reserve for guaranty losses” at the time we acquire the loan.
 
We experienced a substantial increase in the SOP 03-3 fair value losses recorded upon the purchase of delinquent loans from MBS trusts for the first nine months of 2008 relative to the first nine months of 2007, due to the significant disruption in the mortgage market and severe reduction in market liquidity for certain mortgage products, such as delinquent loans, that has persisted since July 2007. As indicated in Table 9 above, SOP 03-3 and HomeSaver Advance fair value losses totaled $519 million and $1.8 billion for the third quarter and first nine months of 2008, respectively, compared to $670 million and $805 million for the third quarter and first nine months of 2007, respectively. The decrease in losses during the third quarter of 2008 reflected the impact of our loss mitigation strategies, including the implementation of HomeSaver Advance to reduce the number of delinquent loans purchased from MBS trusts. We describe how we account for SOP 03-3 fair value losses and the process we use to value loans subject to SOP 03-3 in “Part II—Item 7—MD&A—Critical Accounting Policies and Estimates—Fair Value of Financial Instruments—Fair Value of Loans Purchased with Evidence of Credit Deterioration—Effect on Credit-Related Expenses” of our 2007 Form 10-K.
 
Seriously Delinquent Loans Purchased from MBS Trusts
 
We purchase loans or REO property from MBS trusts for a variety of reasons. Under our trust documents, we are required to purchase loans or REO property from MBS trusts in a number of specified circumstances, including when a mortgage loan becomes and remains delinquent for 24 consecutive months (excluding months during which the borrower is complying with a loss mitigation remedy) and when a mortgage insurer or mortgage guarantor requires the trust to transfer a mortgage loan or related REO property in connection with an insurance or guaranty payment. Our trust documents also provide us with the option to purchase loans from MBS trusts in specified circumstances, such as when four or more consecutive monthly payments due under the loan are delinquent in whole or in part or when the mortgaged property is acquired by the trust as REO property. In general, we do not exercise our contractual option to purchase a delinquent mortgage loan from an MBS trust. If a loan becomes delinquent, we generally attempt to assist the borrower in curing the default and bringing the loan current through our HomeSaver Advance loss mitigation tool. In some circumstances, we may consider purchasing delinquent loans from MBS under our contractual option. Our decision about whether and when to purchase a loan from an MBS trust is based on variety of factors. In general, these factors include: our loss mitigation strategies and the exposure to credit losses we face under our guaranty; our cost of funds and ability to maintain a positive net worth; relevant market yields; the administrative costs associated with purchasing and holding the loan; mission and policy considerations; counterparty exposure to lenders that have agreed to cover losses associated with delinquent loans; general market conditions; our statutory obligations under the Charter Act; and other legal obligations such as those established by consumer finance laws. Our current practices relating to exercising our contractual option to purchase a delinquent mortgage loan from an MBS trust are subject to change, including at the direction of the conservator.
 
Table 11 provides a quarterly comparison of the average market price, as a percentage of the unpaid principal balance and accrued interest, of seriously delinquent loans subject to SOP 03-3 purchased from MBS trusts and additional information related to these loans. Beginning in November 2007, we decreased the number of optional delinquent loan purchases from our single-family MBS trusts in order to preserve capital in compliance with our regulatory capital requirements. HomeSaver Advance, which we implemented in the first quarter of 2008, has reduced the level of our optional delinquent loan purchases. The decline in national home prices and significant reduction in liquidity in the mortgage markets, along with the increase in mortgage


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credit risk, that was observed in the second half of 2007 has persisted and become severe, resulting in continued downward pressure on the value of the collateral underlying these loans.
 
Table 11:  Statistics on Delinquent Loans Purchased from MBS Trusts Subject to SOP 03-3
 
                                                         
    2008     2007  
    Q3     Q2     Q1     Q4     Q3     Q2     Q1  
 
Average market price(1)
    49 %     53 %     60 %     70 %     72 %     93 %     94 %
Unpaid principal balance and accrued interest of loans purchased (dollars in millions)
  $ 744     $ 807     $ 1,704     $ 1,832     $ 2,349     $ 881     $ 1,057  
Number of delinquent loans purchased
    3,678       4,618       10,586       11,997       15,924       6,396       8,009  
 
 
(1) The value of primary mortgage insurance is included as a component of the average market price.
 
Table 12 presents activity related to delinquent loans subject to SOP 03-3 purchased from MBS trusts under our guaranty arrangements for the three months ended September 30, 2008, June 30, 2008 and March 31, 2008.
 
Table 12:  Activity of Delinquent Loans Purchased from MBS Trusts Subject to SOP 03-3
 
                                 
                Allowance
       
    Contractual
    Market
    for Loan
    Net
 
    Amount(1)     Discount     Losses     Investment  
    (Dollars in millions)  
 
Balance as of December 31, 2007
  $ 8,096     $ (991 )   $ (39 )   $ 7,066  
Purchases of delinquent loans
    1,704       (728 )           976  
Provision for credit losses
                (35 )     (35 )
Principal repayments
    (180 )     46       1       (133 )
Modifications and troubled debt restructurings
    (915 )     331       5       (579 )
Foreclosures, transferred to REO
    (619 )     169       18       (432 )
                                 
Balance as of March 31, 2008
  $ 8,086     $ (1,173 )   $ (50 )   $ 6,863  
Purchases of delinquent loans
    807       (380 )           427  
Provision for credit losses
                (86 )     (86 )
Principal repayments
    (192 )     28       2       (162 )
Modifications and troubled debt restructurings
    (582 )     240       5       (337 )
Foreclosures, transferred to REO
    (471 )     129       15       (327 )
                                 
Balance as of June 30, 2008
  $ 7,648     $ (1,156 )   $ (114 )   $ 6,378  
Purchases of delinquent loans
    744       (348 )           396  
Provision for credit losses
                12       12  
Principal repayments
    (148 )     23       2       (123 )
Modifications and troubled debt restructurings
    (472 )     198       9       (265 )
Foreclosures, transferred to REO
    (406 )     128       (17 )     (295 )
                                 
Balance as of September 30, 2008
  $ 7,366     $ (1,155 )   $ (108 )   $ 6,103  
                                 
 
 
(1) Reflects contractually required principal and accrued interest payments that we believe are probable of collection.
 
Tables 13 and 14 provide information about the re-performance, or cure rates, of seriously delinquent single-family loans we purchased from MBS trusts during the first three quarters of 2008, each of the quarters for 2007 and each of the years 2004 to 2007, as of both (1) September 30, 2008 and (2) the end of each respective period in which the loans were purchased. Table 13 includes all seriously delinquent loans we purchased from our MBS trusts, while Table 14 includes only those seriously delinquent loans that we purchased from our MBS trusts because we intended to modify the loan.
 
We believe there are inherent limitations in the re-performance statistics presented in Tables 13 and 14, both because of the significant lag between the time a loan is purchased from an MBS trust and the conclusion of


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the delinquent loan resolution process and because, in our experience, it generally takes at least 18 to 24 months to assess the ultimate re-performance of a delinquent loan. Accordingly, these re-performance statistics, particularly those for more recent loan purchases, are likely to change, perhaps materially. As a result, we believe the re-performance rates as of September 30, 2008 for delinquent loans purchased from MBS trusts during 2008 and 2007 may not be indicative of the ultimate long-term performance of these loans. In addition, our cure rates may be affected by changes in our loss mitigation efforts and delinquent loan purchase practices.
 
Table 13:   Re-performance Rates of Seriously Delinquent Single-Family Loans Purchased from MBS Trusts(1)
 
                                                                                         
    Status as of September 30, 2008  
    2008     2007                          
    Q3     Q2     Q1     Q4     Q3     Q2     Q1     2007     2006     2005     2004  
 
Cured without modification(2)
    6 %     15 %     15 %     16 %     19 %     18 %     25 %     19 %     37 %     44 %     43 %
Cured with modification(3)
    32       41       39       27       16       32       28       24       28       16       15  
                                                                                         
Total cured
    38       56       54       43       35       50       53       43       65       60       58  
Defaults(4)
    4       6       9       21       36       24       27       28       24       33       37  
90 days or more delinquent
    58       38       37       36       29       26       20       29       11       7       5  
                                                                                         
Total
    100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %
                                                                                         
 
                                                                                         
    Status as of the End of Each Respective Period  
    2008     2007                          
    Q3     Q2     Q1     Q4     Q3     Q2     Q1     2007     2006     2005     2004  
 
Cured without modification(2)
    6 %     10 %     7 %     11 %     10 %     11 %     17 %     16 %     32 %     31 %     33 %
Cured with modification(3)
    32       35       37       26       12       31       26       26       29       12       12  
                                                                                         
Total cured
    38       45       44       37       22       42       43       42       61       43       45  
Defaults(4)
    4       2       2       4       6       3       3       13       9       12       14  
90 days or more delinquent
    58       53       54       59       72       55       54       45       30       45       41  
                                                                                         
Total
    100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %
                                                                                         
 
 
(1) Re-performance rates calculated based on number of loans.
 
(2) Loans classified as cured without modification consist of the following: (1) loans that are brought current without modification; (2) loans that are paid in full; (3) loans that are repurchased by lenders; (4) loans that have not been modified but are returned to accrual status because they are less than 90 days delinquent; (5) loans for which the default is resolved through long-term forbearance; and (6) loans for which the default is resolved through a repayment plan. We do not extend the maturity date, change the interest rate or otherwise modify the principal amount of any loan that we resolve through long-term forbearance or a repayment plan unless we first purchase the loan from the MBS trust.
 
(3) Loans classified as cured with modification consist of loans that are brought current or are less than 90 days delinquent as a result of resolution of the default under the loan through the following: (1) a modification that does not result in a concession to the borrower; or (2) a modification that results in a concession to a borrower, which is referred to as a troubled debt restructuring. Concessions may include an extension of the time to repay the loan beyond its original maturity date or a temporary or permanent reduction in the loan’s interest rate.
 
(4) Consists of foreclosures, preforeclosure sales, sales to third parties and deeds in lieu of foreclosure.


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Table 14 below presents cure rates for only those seriously delinquent single-family loans that have been modified after their purchase from MBS trusts. The cure rates for these modified seriously delinquent loans differ substantially from those shown in Table 13, which presents the information for all seriously delinquent loans purchased from our MBS trusts. Loans that have not been modified tend to start with a lower cure rate than those of modified loans, and the cure rate tends to rise over time as loss mitigation strategies for those loans are developed and then implemented. In contrast, modified loans tend to start with a high cure rate, and the cure rate tends to decline over time. For example, as shown below in Table 14, the initial cure rate for modified loans as of the end of 2007 was 85%, compared with 64% as of September 30, 2008.
 
Table 14:   Re-performance Rates of Seriously Delinquent Single-Family Loans Purchased from MBS Trusts and Modified(1)
 
                                                                                         
    Status as of September 30, 2008  
    2008     2007                          
    Q3     Q2     Q1     Q4     Q3     Q2     Q1     2007     2006     2005     2004  
 
Cured
    98 %     85 %     74 %     65 %     61 %     64 %     68 %     64 %     77 %     74 %     71 %
Defaults(2)
                1       2       5       7       8       5       9       13       18  
90 days or more delinquent
    2       15       25       33       34       29       24       31       14       13       11  
                                                                                         
Total
    100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %
                                                                                         
 
                                                                                         
    Status as of the End of Each Respective Period  
    2008     2007                          
    Q3     Q2     Q1     Q4     Q3     Q2     Q1     2007     2006     2005     2004  
 
Cured
    98 %     99 %     99 %     100 %     100 %     99 %     99 %     85 %     91 %     87 %     88 %
Defaults(2)
                                              1       1       1       1  
90 days or more delinquent
    2       1       1                   1       1       14       8       12       11  
                                                                                         
Total
    100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %
                                                                                         
 
 
(1) Re-performance rates calculated based on number of loans.
 
(2) Consists of foreclosures, preforeclosure sales, sales to third parties and deeds in lieu of foreclosure.
 
The substantial majority of the loans reported as cured in Tables 13 and 14 above represent loans for which we believe it is probable that we will collect all of the original contractual principal and interest payments because one or more of the following has occurred: (1) the borrower has brought the loan current without servicer intervention; (2) the loan has paid off; (3) the lender has repurchased the loan; or (4) we have resolved the loan through modification, long-term forbearances or repayment plans. The variance in the cumulative cure rates as of September 30, 2008, compared with the cure rates as of the end of each period in which the loans were purchased from the MBS trust, as displayed in Tables 13 and 14, is primarily due to the amount of time that has elapsed since the loan was purchased to allow for the implementation of a workout solution if necessary.
 
A troubled debt restructuring is the only form of modification in which we do not expect to collect the full original contractual principal and interest amount due under the loan, although other resolutions and modifications may result in our receiving the full amount due, or certain installments due, under the loan over a period of time that is longer than the period of time originally provided for under the loan. Of the percentage of loans in Table 14 reported as cured as of September 30, 2008 for the first three quarters of 2008 and for the years 2007, 2006, 2005 and 2004, approximately 80%, 69%, 63%, 37%, 16% , 4% and 2%, respectively, represented troubled debt restructurings where we have provided a concession to the borrower.


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Required and Optional Purchases of Single Family Loans from MBS Trusts
 
Table 15 presents information on our required and optional purchases of single-family loans from MBS trusts. In this table, we include under “required purchases” our purchases of loans we plan to modify, which typically are considered optional purchases under the trust agreements governing the MBS trusts, because we are not permitted to modify a loan under those trust agreements as long as the loan remains in the MBS trust. Accordingly, we effectively are required to purchase any loans that we plan to modify from the MBS trust.
 
Table 15:   Required and Optional Purchases of Single-Family Loans from MBS Trusts
 
                                         
          Approximate
    Aggregate
             
    Serious
    Number of
    Unpaid
             
    Delinquency
    Loans
    Principal
    Required
    Optional
 
    Rate(1)     Purchased     Balance(2)     Purchases(3)(4)     Purchases(4)(5)  
    (Dollars in billions)  
 
For the quarter ended:
                                       
December 31, 2007
    0.67 %     13,200     $ 2.0       74 %     26 %
March 31, 2008
    0.85       11,400       1.8       97       3  
June 30, 2008
    1.10       5,000       0.9       91       9  
September 30, 2008
    1.46       3,900       0.7       76       24  
 
 
(1) Represents serious delinquency rates for conventional single-family loans in Fannie Mae MBS trusts.
 
(2) Represents unpaid principal balance and accrued interest for single-family loans purchased from MBS trusts during the quarter.
 
(3) Calculated based on the number of loans purchased that we have classified as “required purchases,” divided by the total number of loans we purchased from MBS trusts, during the quarter. Under the applicable trust agreements governing the MBS trusts, we are required to purchase loans from MBS trusts in specific circumstances and have the option to purchase loans from MBS trusts under other conditions.
 
(4) Beginning with the quarter ended September 30, 2008, we re-examined and enhanced our system for classifying purchases from MBS trusts as required or optional. If we had we applied the same classifications in prior quarters, our required purchases for the quarters ended December 31, 2007, March 31, 2008, and June 30, 2008, would have been 47%, 80% and 91%, respectively, and our optional purchases for each of those quarters would have been 53%, 20%, and 9%, respectively.
 
(5) Calculated based on the number of loans purchased on an optional basis divided by the total number of loans we purchased from MBS trusts during the quarter.
 
The proportion of delinquent loans purchased from MBS trusts for the purpose of modification varies from period to period, driven primarily by factors such as changes in our loss mitigation efforts, as well as changes in interest rates and other market factors. The implementation of HomeSaver Advance has contributed to a reduction in the number of delinquent loans we purchase from MBS trusts. We purchased approximately 45,000 unsecured, outstanding HomeSaver Advance loans with an unpaid principal balance of $301 million as of September 30, 2008. The average advance made was approximately $6,700. These loans, which we report in our condensed consolidated balance sheets as a component of “Other assets,” are recorded at their estimated fair value at the date of purchase and assessed for impairment subsequent to the date of purchase. The carrying value of our HomeSaver Advances was $7 million as of September 30, 2008. The fair value of these loans is substantially less than the outstanding unpaid principal balance for several reasons, including the lack of underlying collateral to secure the loans, the large discount that market participants have placed on mortgage-related financial assets, and the uncertainty about how these loans will perform given the current housing market and insufficient amount of time to adequately assess their performance. Several months of payment history is generally required to assess the status of loans that have been resolved through workout alternatives, such as HomeSaver Advance. Because HomeSaver Advance was introduced in 2008, we do not have sufficient history to fully assess the performance of the first lien loans associated with HomeSaver Advance loans.
 
We expect HomeSaver Advance to continue to reduce the number of delinquent loans that we otherwise would have purchased from our MBS trusts for the remainder of 2008. Although our loan purchases have decreased since the end of 2007, we expect that our SOP 03-3 fair value losses for 2008 will be higher than the losses


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recorded for 2007, based on the number of required and optional loans we purchased from MBS trusts during the first nine months of 2008 and the continued weakness in the housing market, which has reduced the underlying value of these loans.
 
Credit Loss Performance Metrics
 
Management views our credit loss performance metrics, which include our historical credit losses and our credit loss ratio, as significant indicators of the effectiveness of our credit risk management strategies. Management uses these metrics together with other credit risk measures to assess the credit quality of our existing guaranty book of business, make determinations about our loss mitigation strategies, evaluate our historical credit loss performance and determine the level of our loss reserves. These metrics, however, are not defined terms within GAAP and may not be calculated in the same manner as similarly titled measures reported by other companies. Because management does not view changes in the fair value of our mortgage loans as credit losses, we exclude SOP 03-3 and HomeSaver Advance fair value losses from our credit loss performance metrics. However, we include in our credit loss performance metrics the impact of any credit losses we experience on loans subject to SOP 03-3 or first lien loans associated with HomeSaver Advance loans that ultimately result in foreclosure.
 
We believe that our credit loss performance metrics are useful to investors because they reflect how management evaluates our credit performance and the effectiveness of our credit risk management strategies and loss mitigation efforts. They also provide a consistent treatment of credit losses for on- and off-balance sheet loans. Moreover, by presenting credit losses with and without the effect of SOP 03-3 and HomeSaver Advance fair value losses, investors are able to evaluate our credit performance on a more consistent basis among periods.
 
Table 16 below details the components of our credit loss performance metrics, which exclude the effect of SOP 03-3 and HomeSaver Advance fair value losses, for the three and nine months ended September 30, 2008 and 2007.
 
Table 16:   Credit Loss Performance Metrics
 
                                                                 
    For the Three Months Ended September 30,     For the Nine Months Ended September 30,  
    2008     2007     2008     2007  
    Amount     Ratio(1)     Amount     Ratio(1)     Amount     Ratio(1)     Amount     Ratio(1)  
    (Dollars in millions)  
 
Charge-offs, net of recoveries
  $ 2,084       28.6 bp   $ 838       13.1 bp   $ 4,707       22.0 bp   $ 1,222       6.6 bp
Foreclosed property expense
    478       6.5       113       1.8       912       4.3       269       1.4  
Less: SOP 03-3 and HomeSaver Advance fair value losses(2)
    (519 )     (7.2 )     (670 )     (10.6 )     (1,750 )     (8.2 )     (805 )     (4.3 )
Plus: Impact of SOP 03-3 on charge-offs and foreclosed property expense(3)
    128       1.8       62       1.0       426       2.0       113       0.6  
                                                                 
Credit losses(4)
  $ 2,171       29.7 bp   $ 343       5.3 bp   $ 4,295       20.1 bp   $ 799       4.3 bp
                                                                 
 
 
(1) Based on the annualized amount for each line item presented divided by the average guaranty book of business during the period. We previously calculated our credit loss ratio based on annualized credit losses as a percentage of our mortgage credit book of business, which includes non-Fannie Mae mortgage-related securities held in our mortgage investment portfolio that we do not guarantee. Because losses related to non-Fannie Mae mortgage-related securities are not reflected in our credit losses, we revised the calculation of our credit loss ratio to reflect credit losses as a percentage of our guaranty book of business. Our credit loss ratio calculated based on our mortgage credit book of business would have been 28.4 basis points and 5.0 basis points for the three months ended September 30, 2008 and 2007, respectively. Our charge-off ratio calculated based on our mortgage credit book of business would have been 27.3 basis points and 12.3 basis points for the three months ended September 30, 2008 and 2007, respectively. Our credit loss ratio calculated based on our mortgage credit book of business would have been 19.1 basis points and 4.0 basis points for the nine months ended September 30, 2008 and 2007, respectively. Our charge-off ratio calculated based on our mortgage credit book of business would have been 21.0 basis points and 6.2 basis points for the nine months ended September 30, 2008 and 2007, respectively.


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(2) Represents the amount recorded as a loss when the acquisition cost of a delinquent loan purchased from an MBS trust that is subject to SOP 03-3 exceeds the fair value of the loan at acquisition. Also includes the difference between the unpaid principal balance of HomeSaver Advance loans at origination and the estimated fair value of these loans that we record in our condensed consolidated balance sheets.
 
(3) For seriously delinquent loans purchased from MBS trusts that are recorded at a fair value amount at acquisition that is lower than the acquisition cost, any loss recorded at foreclosure would be less than it would have been if we had recorded the loan at its acquisition cost instead of at fair value. Accordingly, we have added back to our credit losses the amount of charge-offs and foreclosed property expense that we would have recorded if we had calculated these amounts based on the purchase price.
 
(4) Interest forgone on nonperforming loans in our mortgage portfolio, which is presented in Table 44, reduces our net interest income but is not reflected in our credit losses total. In addition, other-than-temporary impairment losses resulting from deterioration in the credit quality of our mortgage-related securities and accretion of interest income on loans subject to SOP 03-3 are excluded from credit losses.
 
Our credit loss ratio increased to 29.7 basis points and 20.1 basis points for the third quarter and first nine months of 2008, respectively, from 5.3 basis points and 4.3 basis points for the third quarter and first nine months of 2007, respectively. The substantial increase in our credit losses reflected the impact of a further deterioration of conditions in the housing and credit markets. The national decline in home prices and the general economic weakness affecting many states, including those in the Midwest, have continued to contribute to higher default rates and loan loss severities, particularly for certain higher risk loan categories, loan vintages and loans within certain states that have had the greatest home price depreciation from their recent peaks. Our credit loss ratio including the effect of SOP 03-3 and HomeSaver Advance fair value losses was 35.1 basis points and 26.3 basis points for the third quarter and first nine months of 2008, respectively, and 14.9 basis points and 8.0 basis points for the third quarter and first nine months of 2007, respectively.
 
Certain higher risk loan types, such as Alt-A loans, interest-only loans, loans to borrowers with low credit scores and loans with high loan-to-value ratios, many of which were originated in 2006 and 2007, represented approximately 28% of our single-family conventional mortgage credit book of business as of September 30, 2008, but accounted for approximately 72% and 71% of our single-family credit losses for the third quarter and first nine months of 2008, respectively, compared with 56% and 53% for the third quarter and first nine months of 2007, respectively.
 
The states of California, Florida, Arizona and Nevada, which represented approximately 27% of our single-family conventional mortgage credit book of business as of September 30, 2008, accounted for 55% and 48% of our single-family credit losses for the third quarter and first nine months of 2008, respectively, compared with 17% and 10% for the third quarter and first nine months of 2007, respectively. Michigan and Ohio, two key states driving credit losses in the Midwest, represented approximately 6% of our single-family conventional mortgage credit book of business as of September 30, 2008, but accounted for 14% and 18% of our single-family credit losses for the third quarter and first nine months of 2008, respectively, compared with 39% and 41% for the third quarter and first nine months of 2007, respectively.
 
We provide more detailed credit performance information, including serious delinquency rates by geographic region, statistics on nonperforming loans and foreclosed property activity, in “Risk Management—Credit Risk Management—Mortgage Credit Risk Management—Mortgage Credit Book of Business.”
 
Regulatory Hypothetical Stress Test Scenario
 
Pursuant to a September 2005 agreement with OFHEO, we disclose on a quarterly basis the present value of the change in future expected credit losses from our existing single-family guaranty book of business from an immediate 5% decline in single-family home prices for the entire United States. Table 17 shows the credit loss sensitivity before and after consideration of projected credit risk sharing proceeds, such as private mortgage insurance claims and other credit enhancement, as of September 30, 2008 and December 31, 2007 for first lien single-family whole loans we own or that back Fannie Mae MBS. The sensitivity results represent the difference between our base case scenario of the present value of expected credit losses and credit risk sharing proceeds, derived from our internal home price path forecast, and a scenario that assumes an instantaneous nationwide 5% decline in home prices.


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Table 17:   Single-Family Credit Loss Sensitivity(1)
 
                 
    As of  
    September 30,
    December 31,
 
    2008     2007  
    (Dollars in millions)  
 
Gross single-family credit loss sensitivity(2)
  $ 12,766     $ 9,644  
Less: Projected credit risk sharing proceeds
    (3,898 )     (5,102 )
                 
Net single-family credit loss sensitivity(2)
  $ 8,868     $ 4,542  
                 
Outstanding single-family whole loans and Fannie Mae MBS
  $ 2,693,735     $ 2,523,440  
Single-family net credit loss sensitivity as a percentage of outstanding single-family whole loans and Fannie Mae MBS
    0.33 %     0.18 %
 
 
(1) For purposes of this calculation, we assume that, after the initial 5% shock, home price growth rates return to the average of the possible growth rate paths used in our internal credit pricing models. The present value change reflects the increase in future expected credit losses under this shock scenario.
 
(2) Represents total economic credit losses, which consist of credit losses and forgone interest. Calculations are based on approximately 97% of our total single-family guaranty book of business as of both September 30, 2008 and December 31, 2007. The mortgage loans and mortgage-related securities that are included in these estimates consist of: (i) single-family Fannie Mae MBS (whether held in our mortgage portfolio or held by third parties), excluding certain whole loan REMICs and private-label wraps; (ii) single-family mortgage loans, excluding mortgages secured only by second liens, subprime mortgages, manufactured housing chattel loans and reverse mortgages; and (iii) long-term standby commitments. We expect the inclusion in our estimates of the excluded products may impact the estimated sensitivities set forth in this table.
 
The increase in the credit loss sensitivities since December 31, 2007 reflects the decline in home prices during the first nine months of 2008 and the current negative near-term outlook for the housing and credit markets. These higher sensitivities also reflect the impact of updates to our underlying credit loss estimation models to capture the credit risk associated with the rapidly deteriorating conditions in the housing market. An environment of continuing lower home prices affects the frequency and timing of defaults and increases the level of credit losses, resulting in greater loss sensitivities. Although the anticipated credit risk sharing proceeds have increased as home prices have declined, the expected amount of proceeds resulting from a 5% home price shock are lower. As home prices decline, the number of loans without mortgage insurance that are projected to default increases and the losses on loans with mortgage insurance that default are more likely to increase to a level that exceeds the level of mortgage insurance.
 
Our regulatory stress test scenario assumes an instantaneous uniform 5% nationwide decline in home prices, which is not representative of the historical pattern of changes in home prices. Changes in home prices generally vary on a regional basis. In addition, the stress test scenario is calculated independently without considering changes in other interrelated assumptions, such as unemployment rates or other economic factors, would likely have a significant impact on our future expected credit losses.
 
Other Non-Interest Expenses
 
Other non-interest expenses consists of credit enhancement expenses, which reflect the amortization of the credit enhancement asset we record at the inception of guaranty contracts, costs associated with the purchase of additional mortgage insurance to protect against credit losses, net gains and losses on the extinguishment of debt, the accrual of the costs of our possible contribution to the affordable housing trust fund, regulatory penalties and other miscellaneous expenses. Other non-interest expenses increased to $147 million and $938 million for the third quarter and first nine months of 2008, respectively, from $95 million and $259 million for the third quarter and first nine months of 2007, respectively. The increase in expenses for the third quarter of 2008 was predominately due to the accrual of the costs of our possible contribution to the affordable housing trust fund. Although we are accruing amounts for payment to the affordable housing trust fund, the amount of our first contribution has not yet been determined. The Director of FHFA has the authority to temporarily suspend this requirement if payment would contribute to our financial instability, cause us to be classified as undercapitalized or prevent us from successfully completing a capital restoration plan. The increase in expenses for the first nine months of 2008 was predominately due to a reduction in the


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amount of net gains recognized on the extinguishment of debt and interest expense related to an increase in our unrecognized tax benefit.
 
Federal Income Taxes
 
Although we incurred pre-tax losses for the third quarter and first nine months of 2008, we did not record a tax benefit for these losses. Instead, we recorded a provision for federal income taxes of $17.0 billion and $13.6 billion for the third quarter and first nine months of 2008, respectively. These amounts reflect the impact of a non-cash charge of $21.4 billion recorded in the third quarter of 2008 to establish a partial deferred tax asset valuation allowance against our net deferred tax assets as of September 30, 2008. As a result of the partial valuation allowance, we did not record tax benefits for the majority of the losses we incurred during the third quarter and first nine months of 2008. We discuss the factors that led us to record a partial valuation allowance against our net deferred tax assets in “Critical Accounting Policies and Estimates—Deferred Tax Assets” and “Notes to Condensed Consolidated Financial Statements—Note 11, Income Taxes.”
 
The amount of deferred tax assets considered realizable is subject to adjustment in future periods. We will continue to monitor all available evidence related to our ability to utilize our remaining deferred tax assets. If we determine that recovery is not likely, we will record an additional valuation allowance against the deferred tax assets that we estimate may not be recoverable. Our income tax expense in future periods will be reduced or increased to the extent of offsetting decreases or increases to our valuation allowance.
 
We recorded a tax benefit of $582 million and $468 million for the third quarter and first nine months of 2007, respectively, which resulted from the combined effect of a pre-tax loss for the third quarter of 2007 and tax credits generated from our LIHTC partnership investments.
 
BUSINESS SEGMENT RESULTS
 
The presentation of the results of each of our three business segments is intended to reflect each segment as if it were a stand-alone business. We describe the management reporting and allocation process that we use to generate our segment results in our 2007 Form 10-K in “Notes to Consolidated Financial Statements—Note 15, Segment Reporting.” We summarize our segment results for the three and nine months ended September 30, 2008 and 2007 in the tables below and provide a discussion of these results. We include more detail on our segment results in “Notes to Condensed Consolidated Financial Statements—Note 14, Segment Reporting.”
 
Single-Family Business
 
Our Single-Family business recorded a net loss of $14.2 billion and $17.6 billion for the third quarter and first nine months of 2008, respectively, compared with a net loss of $186 million for the third quarter of 2007 and net income of $305 million for the first nine months of 2007. Table 18 summarizes the financial results for our Single-Family business for the periods indicated.


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Table 18:   Single-Family Business Results
 
                                                                 
    For the
    For the
             
    Three Months Ended
    Nine Months Ended
    Quarterly
    Year-to-Date
 
    September 30,     September 30,     Variance     Variance  
    2008     2007     2008     2007     $     %     $     %  
    (Dollars in millions)  
 
Statement of operations data:
                                                               
Guaranty fee income
  $ 1,674     $ 1,424     $ 5,435     $ 4,015     $ 250       18 %   $ 1,420       35 %
Trust management income
    63       138       242       433       (75 )     (54 )     (191 )     (44 )
Other income(1)(2)
    184       133       569       493       51       38       76       15  
Losses on certain guaranty contracts
          (292 )           (1,023 )     292       100       1,023       100  
Credit-related expenses(3)
    (9,215 )     (1,195 )     (17,808 )     (2,040 )     (8,020 )     (671 )     (15,768 )     (773 )
Other expenses(1)(4)
    (383 )     (492 )     (1,377 )     (1,414 )     109       22       37       3  
                                                                 
Income (loss) before federal income taxes
    (7,677 )     (284 )     (12,939 )     464       (7,393 )     (2,603 )     (13,403 )     (2,889 )
Benefit (provision) for federal income taxes
    (6,550 )     98       (4,702 )     (159 )     (6,648 )     (6,784 )     (4,543 )     (2,857 )
                                                                 
Net income (loss)
  $ (14,227 )   $ (186 )   $ (17,641 )   $ 305     $ (14,041 )     (7,549 )%   $ (17,946 )     (5,884 )%
                                                                 
Other key performance data:
                                                               
Average single-family guaranty book of business(5)
  $ 2,753,293     $ 2,432,904     $ 2,693,909     $ 2,359,126     $ 320,389       13 %   $ 334,783       14 %
 
 
(1) Certain prior period amounts have been reclassified to conform with the current period presentation in our condensed consolidated statements of operations.
 
(2) Consists of net interest income, investment gains and losses, and fee and other income.
 
(3) Consists of the provision for credit losses and foreclosed property expense.
 
(4) Consists of administrative expenses and other expenses.
 
(5) The single-family guaranty book of business consists of single-family mortgage loans held in our mortgage portfolio, single-family Fannie Mae MBS held in our mortgage portfolio, single-family Fannie Mae MBS held by third parties, and other credit enhancements that we provide on single-family mortgage assets. Excludes non-Fannie Mae mortgage-related securities held in our investment portfolio for which we do not provide a guaranty.
 
Key factors affecting the results of our Sin